September 27, 2002
Financial Systems and Growth Prospects in Asia

Financial Systems and Growth Prospects in Asia

J. Bradford DeLong, U.C. Berkeley and NBER
September 2002 (after-dinner talk at Federal Reserve Bank of San Francisco/Journal of the Japanese and International Economies conference on Financial Issues in the Pacific Basin Region)

This topic, "Growth Prospects in Asia," is a nice one because the answer is easy. Growth prospects in Asia are bright. Our ongoing technological revolutions, the fall in transport and communication costs, and the growth of world trade have created enormous opportunities. East Asia has public officials who are, in world context, remarkably honest; an eagerness to invest in education to a high degree; institutions that have worked in supporting the fastest generation of economic growth anywhere, anytime. These fundamentals plus the still-large productivity gap between Asia--even Japan--and the North Atlantic core of the world economy create the potential for at least one further generation of extraordinarily rapid economic growth in Asia

But...

It was John Maynard Keynes who looked forward to and thought it would be "splendid" if economists were "like dentists": competent people, with effective tools and sound knowledge, whom you could call in to fix some discrete problem--an impacted molar, say--and then after a little temporary pain, and a short period of post-operative treatment and recovery, resume your normal life.

If we want to take this analogy and run with it, the Asian economies had three different serious oral health problems in the 1990s--problems that required oral surgery, and not just repeated admonitions to brush your teeth longer and more vigorously after meals. The first of these was the current Japanese quiet depression: generated by the fallout from the collapse of Japanese equity and property values at the end of the 1990s. This is a serious problem causing prolonged and sharp pain that calls for a major operation--a root-canal, say--which has been delayed and is being delayed, as root canals are often delayed, out of fear that the further pain the dentists will inflict in the course of the operation will be neither minor nor temporary.

The second was the Asian financial crisis: generated by the combination of the 1997 loss of confidence in Asia by New York investors and the fact that so much of Asia's debt was dollar-denominated, hence we got an object lesson in both the importance of multiple equilibria in economic models and in how our previous failure to take units of account seriously had been an impediment to our vision. We can analogize this problem to that of a single decayed tooth urgently requiring a filling. A very large filling, I admit--some $50 billion of official support, and even so devaluations that seemed larger than justified by fundamentals. And a substantial amount of pain: a five percent fall in the real GDP of developing East Asia (outside China) in 1998. But the pain was temporary. Growth resumed. And if growth this year and next year is not up to its pre-1997 standard, that has at least as much to do with the recession in the U.S., the world's importer of last resort, as with the fallout from the 1997-1998 crisis.

The third is a deeper factor that contributed to causing the 1997-1998 Asian financial crisis, but that is threatening on its own as well: the fear that Asian countries outside of Japan have in an important way gotten financial institutions--both private financial institutions of control and surveillance over operating corporations, and public institutions of surveillance and supervision that regulate the private financial institutions--wrong. The best analogy for this problem is of a nagging ache to the jaw before one has seen the dentist: we don't know how serious the problem is. Here, however, the analogy breaks down: with dentists, you can consult them and they can provide a reliable diagnosis; with economists, you cannot.

Our ongoing technological revolutions, the fall in transport and communication costs, and the growth of world trade have, to continue the analogy, set the table with an extraordinarily attractive meal. Very strong growth fundamentals plus the still-large productivity gap between Asia--even Japan--and the North Atlantic core of the world economy create the potential for at least one further generation of extraordinarily rapid economic growth in Asia--if our teeth turn out to be healthy enough to actually eat the meal. So it will be very disappointing if complete oral health cannot be attained.

Let me go back over these three problems in somewhat more detail.

Japan's now decade-long quiet depression of upward-creeping unemployment, extremely anemic growth during expansion, and frequent recessions--we are now in the third such in a decade--is not something about which a great deal new can be said. Macroeconomic tools have proven much less powerful than everyone had hoped, and there is a near-consensus that this is due, as this week's IMF World Economic Outlook says, to the badly impacted state of "the banking sector, where a vicious circle needs to be broken in which large unrecognized nonperforming loans make banks unwilling to lend, hurting financial intermediation and activity, and thereby creating new nonperforming loans to replace those being [slowly] written off." The United States dealt with a much smaller but analogous problem at the start of the 1990s, with the use of the Resolution Trust Corporation to undertake a mass nationalization of zombie S&Ls and then a mass privatization of those parts of the S&Ls that could be pulled back above water. Japan hesitates--for reasons of internal Japanese politics that we economists dismiss as unworthy of our consideration, and out of the fear that recognition of the size of the problem and liquidation of zombie banks and firms will cause a panic that will deepen Japan's conventional macroeconomic demand deficit. It is hard not to sympathize with delay, but without action I at least see no way that Japanese economy will recover--no way that Asia will be able to use its left lower jaw to chew and eat the economic growth meal that our modern technological revolutions and falling transport and communication costs have put on the table.

In retrospect, it is hard for me at least not to admire the job of practical roadside emergency dentistry that was performed to deal with the 1997-1998 financial crisis. Nobody had anticipated the speed with which first-world investors in New York and elsewhere would decide to bail from a region that had, over the previous generation, delivered the fastest economic growth the world has ever seen, anywhere, anytime. Few people recognized in advance how large the region's hard-currency debts were, and how sharp were the horns of the dilemma--keep interest rates on government debt low, and find that currency depreciation and the resulting increase in the domestic-currency value of debt had put so many firms and institutions underwater and pushed risk premia so high that the economy went into deep depression, or push up interest rates on government debt to try to curb currency depreciation, and find that high domestic interest rates had put so many firms and institutions underwater that the economy went into deep depression.

It is true that the IMF showed up at the scene of the toothache thinking initially that this was a Latin American-style profligate government crisis, and spent several months counterproductively searching for the hidden public-sector deficits that it thought must be at the root of the problem. It is true that throughout the crisis the IMF couldn't resist micromanagement: every mission chief saw the crisis as an opportunity to do favors for his friends in the local Department of Finance by advancing their (largely sound) agendas for prudence and reform. (And Morris Goldstein and Marty Feldstein, at least, believe that this micromanagement badly undermined the IMF's authority.) But the most important thing the IMF did was show up with the gold to fill the hole in the tooth. And--once the filling was in place--things were fixed: that part of the jaw chews fine. Growth recovered and came close to its pre-1997 pace--except for years like last year when outside demand for East Asian exports fell off. The net capital inflow to East Asia to finance development did not resume, but that is more likely to reflect the combination of the U.S. trade deficit and certain arithmetic identities in international economics than a lingering fallout from 1997-1998. And the most important flow of capital into East Asia--the flow of Foreign Direct Investment that may well be the carrier of a lot of technology transfer--was barely interrupted at all. If we think of the Japanese situation as analogous to a root-canal operation that the patient is still too scared to schedule, we should think of the East Asian crisis of 1997-1998 as analogous to a successful emergency roadside filling.

However, these are not the only two oral health problems Asia had in the 1990s. The third--and fear of it was a major cause of the 1997-1998 financial crisis--is the possibility that Asia does not have government regulatory institutions of the strength and competence it needs to properly supervise its financial sectors, and that Asia has chosen a model for private-side finance-industry relations--corporate control and supervision--that served Germany well in 1900 and served Japan well in 1970, but that is poorly fitted for the world of today and tomorrow.

Now failures of regulatory institutions are not confined to the far side of the Pacific Ocean. In the about-to-be-distributed issue of the Atlantic Monthly, Joe Stiglitz fires up his flamethrower and tries to retrospectively revoke the license to practice dentistry of the Bentsen Treasury--in which I worked--because of its pressuring of FASB not to tighten up on options-reporting requirements. In this criticism, at least, Joe is completely right. Failures of financial and other private-sector mechanisms of corporate control to even be aware of the extent of self-dealing and the existence of risks are not confined to the far side of the Pacific Ocean. Nothing I ever read about crony capitalism in East Asia approaches Fastow's Raptor off-balance-sheet vehicles at Enron. My head still spins at remembering Senator Gramm's denunciations of crony capitalists and do-nothing monitors when I think that at the same time his wife was on Enron's audit committee. And nothing I ever read about blithe overoptimism and lack of concern about what East Asian companies were doing with their investor's money matched major New York financial institutions' willingness to lend to the highly-leveraged LTCM without even a shred of due diligence.

Nevertheless, the fact that we in the U.S. share the same problems does not mean that East Asia does not need to have financial regulators that can do a better job of monitoring and controlling the systemic risks its financial institutions' transactions create. It does not mean that East Asia does not need to rely more on public information dissemination and arms-length market transactions and less on long-term "relationships" in determining what and how operating companies get to use other people's money. The most powerful argument, I think, for attempting to move further away from a Germano-Japanese and toward an Anglo-American financial system is simply that the U.S. is the center of the world economy, that the ability to draw on New York-based finance is a very valuable social asset, and that will be hard to do if information is not presented and corporations are not governed and supervised in a way familiar to New York.

Here, as I said before, the analogy with dentistry breaks down. There is nobody we can go to to diagnose how serious this third oral health issue is. It may prove to be not very important at all. It may prove to be important indeed.

The fact that we have to say that only one of the three oral health problems of Asia in the 1990s has been successfully dealt with is bitterly disappointing. Our ongoing technological revolutions, the fall in transport and communication costs, and the growth of world trade have, to continue the analogy, set the table with an extraordinarily attractive meal. Public officials who are, in world context, remarkably honest; an eagerness to invest in education to a high degree; institutions that have worked in supporting the fastest generation of economic growth anywhere, anytime. These fundamentals plus the still-large productivity gap between Asia--even Japan--and the North Atlantic core of the world economy create the potential for at least one further generation of extraordinarily rapid economic growth in Asia--if our teeth turn out to be healthy enough to actually eat the meal. But aggregate demand has to be kept high. Zombie institutions have to be dealt with so as not to generate large risk and default premia for all borrowers. International financial crises need to be headed off before and managed after they occur. And the public and private institutional framework has to be both effective and comfortable for New York-based world finance.

Keynes would be disappointed, because we are really not yet very much like dentists at all.

Posted by DeLong at September 27, 2002 11:47 AM | Trackback

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This is the first sentence after the graph. I cannot make sense of it:

"The third is a deeper factor that contributed to causing the 1997-1998 Asian financial crisis, but that is threatening on its own as well: the fear that Asian countries outside of Japan have in an important way gotten financial institutions--both private financial institutions of control and surveillance over operating corporations, and public institutions of surveillance and supervision that regulate the private financial institutions."

The core sentence (removing the intro before the : and the offset phrase after the --, which simply defines "financial institutions") is:

"the fear that Asian countries outside of Japan have in an important way gotten financial institutions"

which means nothing to me, and neither can I intuit a fix.

Posted by: David Margolies on September 27, 2002 12:15 PM

Replace "gotten" with "rotten" and hopefully it'll make sense...

Posted by: Amit Dubey on September 27, 2002 12:22 PM

It does. Thanks.

Posted by: David Margolies on September 27, 2002 01:03 PM

"Japan hesitates -- for reasons of internal Japanese politics that we economists dismiss as unworthy of our consideration..."

I'm sure there's a little irony there but there's something serious too. Public choice can have macro effects maybe.

[I appreciate the insight and info in the whole analysis, but having had a recent painful bout with the dentist I kinda wish you hadn't run with the analogy quite that far. I could feel it. ]

Posted by: Jim Glass on September 27, 2002 01:51 PM

I think perhaps Brad is looking at things with eyes that are too economic and not social enough. My questions regarding Asia would be what are the core culture and values of the technocrats (ie the engineers, mid-level managers, accountants and so on, who actually make things happen), and of the CEO class?

Do the CEOs see themselves as owning their companies, to do with as they want? Do they see themselves (honestly, not just lip service) as servants of shareholders? Do they see themselves as the aristocracy, planning the future of the country and grooming its leaders? How receptive are they to outside talent?

As for the technocrats (future upper-middle-class) is their interest in a country where everyone does well and all can sleep happily at night, or is their world view one of a limited pie of which they must grab as large a share as possible?

It's unimportant what the economic fundamentals are if the politics aren't there. China's 8%pa growth rate cannot be extrapolated for 36 years (two doubling periods) if the technocrats and managers create a society in civil war before then. Thailand won't get any outside capital if investors suspect that management have become infested with American ideas and are busily routing as much profit as possible into their salaries and perks rather than into dividends and company growth.

Seriously, Brad, if I knew to whom to speak, these are the questions I'd be asking, not technical questions like expected macro-economic numbers or uptake of computer technology.

Posted by: Maynard Handley on September 27, 2002 06:08 PM

Maynard writes: "Thailand won't get any outside capital if investors suspect that management have become infested with American ideas and are busily routing as much profit as possible into their salaries and perks rather than into dividends and company growth."

That's a remarkable description of how North American management has acted over the last 10 to 20 years. And it as true here as it is there, as we are seeing right now.

Posted by: Ian Welsh on September 27, 2002 08:14 PM

Dang it, 36 yrs at 8%pa is three doubling periods, not two. Must trade in brain for new higher GHz model.

And, of course, my points are not specific to Asia. Ian Welsh picked up on the second point (though I don't believe US investors have yet realized that they are slowly and methodically being screwed---they still think stocks will one day make them rich).

He didn't, however, note that my first point applies equally well to the US. Capitalism in the US was well on the way to destroying itself before FDR and the New Deal. Rather then being grateful, the current generation of conservative twits running the country are determined to destroy whatever they can of the New Deal. If they get away with it, the country has no more instrinsic stability than China, as the mass of people with no stake in the system swells and anger routes in different directions---some wanting to blame foreigners and immigrants for their unhappy lot in life, some wanting to blame the rich, some just wanting to tear down the system, kill and generally cause mayhem, some retreating into a haze of drugs. One can map out any number of scenarios---a new Hitler comes to power, rich coastal states say screw this and try to abandon the interior states, a critical mass of people simply opt out of the system and stop working productively leading to a catastrophic decline in standard of living, and so on---but most of them aren't pretty.

Posted by: Maynard Handley on September 27, 2002 08:44 PM

Maynard, I actually agree with you on the New Deal. The evisceration of the SEC and the repeal of New Deal laws intended to keep the pillars of the financial community apart was a prerequisite for the disasters of ethics and hubris that we have had in the financial community over the last twenty years.

As an aside, a conservative estimate would be that profits in the 90's were overstated by about 20%. It's almost certainly more. I always think I'm beyond shock at the stupidity and venality of our corporate leaders and they always manage to prove me wrong - and each time it becomes clear that annual statements bear even less resemblance to reality than I thought.

Posted by: Ian Welsh on September 28, 2002 10:33 AM

Maynard and Ian - fine discussion.

Posted by: on September 28, 2002 01:45 PM

The high current valuations in our stock market suggest that profits were indeed considerably overstated during the 90's - 20 to 25% percent seems a reasonable estimate range.

Warren Buffett made this estimate at the annual meeting of Berkshire in spring, 2000.

Posted by: on September 28, 2002 02:03 PM

Brad

Terrific talk. Friends in Hong Kong and China are very optimistic about Chinese development prospects, though they continually mention a transition to urban employment of tens of millions of young men and women from rural China. How this transition is handled may be the most important problem for the new Chinese leaders.

Posted by: on September 28, 2002 02:09 PM

in a couple of remarkable articles last wednesday in the FT, david pilling reported on the BoJ's extraordinary decision to buy shares from financial institutions, which had the salutary effect of steepening the yield curve after a failed auction of JGBs.

FRONT PAGE - FIRST SECTION: BoJ takes gamble to avert crisis

"This is our independent decision based on our serious concern about the state of the financial system," said the official. "We are well aware of the risks to our balance sheet. We never meant to do this. But unusual circumstances call for unusual measures."

BACK PAGE - FIRST SECTION: Happy ending elusive for bank that lost its virginity

Last Wednesday Masaru Hayami, governor of the Bank of Japan, called Hakuo Yanagisawa, head of the Financial Services Agency, to explain that the BoJ would in hours take action unprecedented in its 120-year history. It would announce its intention to buy shares from commercial banks.

The reason, Mr Hayami explained, was that the BoJ was so concerned about the financial health of Japanese banks that it felt compelled to shore up the system by putting a floor under tumbling shares owned by banks.

More important, it wanted to send a message to other branches of government, including the FSA, that far more urgent action was needed to deal with Japan's financial crisis.

[...]

Through the BoJ's highly unconventional act of buying banks' shares, toppling all its previous dictums, Mr Hayami was signalling that now was the time to panic.

"We thought some kind of high risk-taking action by the BoJ was necessary to send a meaningful wake-up call," said a senior bank official yesterday. "Action is needed at this critical moment."

The bank's volte face is an extraordinarily bold act, said Peter Tasker of Arcus Investment in Tokyo. "It's a bet by the BoJ that it can shame the other branches of government into action. If the bet is successful, a full-scale programme of bank recapitalisation will emerge. If not, then we will probably be heading for some sort of financial crisis."

[...]

If experienced analysts are nonplussed by the BoJ's action, so apparently is Junichiro Koizumi, the prime minister. He too seems to have been informed of the bank's intended action only hours before Mr Hayami threw down his gauntlet in public.

[...]

"It has become apparent there is no plan," said Mr Tasker. "The political leadership is non-existent in terms of co- ordination or cohesion."

The spectacle of policy being made on the hoof is not only apparent in the lack of co-ordinated response from other branches of government, but even in the sketchy details of the BoJ's plan itself.

[...]

After months of frustration, Mr Hayami, who retires in March, is mounting one last desperate effort to convince other branches of government to act.

the FT also reports that koizumi may be about to sack FSA minister hakuo yanagisawa, btw.

placed in a larger context, what can one ascertain about the some would say drastic measures being taken by japan with regard to the world economy? well, i would say that faced with the prospects of global deflation, currency devalauation (without pegs around! except for HK of course :) and recession, money creation is coming to the fore as the only policy prescription to avert the gathering debt crisis. it sucks and it is super risky if complementary structural reforms are also not implemented concurrently, but the alternatives i think are increasingly less savory.

Posted by: kenny on September 29, 2002 12:27 PM

Let's not be too quick to count out "Germano-Japanese" economics as a contender with the "Anglo-American" model. After all, the economic contest with communism lasted half a century, and these two versions of capitalism are still evolving and not producing orthagonally comparible results on the industrial level.

It might not be too flattering to the view of American economists to compare the performance of Britian over the last half century to that of Japan, after all, even given Japan's macroeconomics over the last decade. The flow of capital ownership, advanced education in engineering and the sciences, industrial capacity of every level and description, trade surpluses, and technology have been consistently in Asia's direction for decades, and that shows no sign of changing in any forseeable future, precisely because of the commitment of these political-economic cultures to contrasting views.

The Anglo-American view that retaining industrial knowledge and technique has essentially no value and that short term stagnation in innovation indicates industrial "maturity" has not proven prophetic in a number of industries, and may have critical mass effects on long term growth if Michael Porter's work on industrial clusters proves more relevant than numerical abstractions that take into account neither culture nor learning nor long term political intention.

It's an interesting contest, probably an historic one, and it may be a bit more clever to study it with respect, rather than to continue to "advise" policies which do not fit the contrasting economics of these cultures. I continue to find it amusing when American economists are baffled when Japan ignores policy advise which has nothing to do with the view their economic model teaches and values. But it is that very blindness (on both sides) that most probably guarentees a long term contrast, and it is this which will in the long run be of real value to the field of economics.

Posted by: BC on October 6, 2002 12:56 AM
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