The Asian crisis occured in 1997. The causes of the crisis have been hotly debated. We can desribe the anatomy of the crisis in structural terms with regard to the Asian countries financial institutions and economies, and in temporal terms within the context of the global economy.
To give a metaphor for the structural and temporal dimensions, we can think of the reasons we might have for building a shelter, and the reasons our shelter may not be strong enough. If we think of time, we can think of seasons where we expect storms and other times sunshine - and we know that storms are inevitable but we cannot predict how heavy they will be. There is always a possibility, no matter how strong a structure, that the storm can destroy it. The question we may be left with, if our house comes down, is whether we could have done something better to protect the house. In the case of economics, we are also left wondering what part we had in creating the storm. Of course, the house is built for many reasons beyond the need for protecting against severe weather, and with scarce resources, we make decisions based on what we know at the time, balancing safety with productivity, enjoyment and the rest. We rely on others, and their knowledge, and we are influenced by the needs of all who will use the house. And we are human, given to human weaknesses, and personal relationships. Should we let our cousin build the foundation? Should we make it larger, but spend less on the foundation? Should we focus on safety, but in doing so sacrifice the attractiveness?
Clearly the decisions made by the Asian countries in terms of their monetary and fiscal policy displayed weakness in the structure that was met with an aggressive investor climate, and asymettric information in financial markets.
1. The House - the Asian economies had the following structural characteristics before the crisis.
- Strong economic growth - 9% over the five years before 1997.
- Capital market liberalization - the elimination of capital controls.
- As argued by Krugman in 1994, traditional economic growth of total factor productivity had slowed but this was masked by short-term capital investment.
- The banking sector was fragile, marked by crony capitalism, expectation of bail-out and irresponsible lending.
- All Asian countries succumbed to current account deficits, Thailand the worst at 8%.
- All but Malaysia had fixed exchange rates or bands (though Malaysia moved to fixed ER in response to its crisis)
2. The climate (temporal context)
- Investors were not motivated to hedge their investments because of fixed ERs
- the domestic private sector was not motivated to hedge their foreign borrowing
- Short-term capital investment was aggressive in the context of capital market liberalization
- Speculation on currency, as well as other investments like real estate was rampant
- The IMF was involved in fiscal policy before, and in response to the crisis, pursuing a contractionary strategy of fiscal discipline that some have argued worsened the problems.
- Crony capitalism led to bad investments and lending.
Where these factors met to cause the crisis (the storm hits the house).
- In May 1997, Thailand spends its foreign reserves trying to defend its currency from speculative attacks
- In July 2, Thailand is forced to de-value its baht, un-hedged investors panic and the baht falls by a record 20%
- Contagion spreads to the other Asian tigers
- Malaysia defends its currency
- Phillipino peso is de-valued
- Indonesia widens its trading band to fend off speculators
- Singapore dollar declines
- Thailand accepts IMF bail-out with tough conditions
- Indonesia abandons the trading band altogether, the currency plunges
- The Hong Kong stock index falls 10.4%, after raising interest rates to fend off speculators.
- Indonesia seeks IMF relief, closes 16 bankrupt banks.
- Korea is unable to defend the Won which falls to a record low and then requests and gets IMF aid, largest package in history
- as part of IMF plan, Thailand closed 56 finance companies.
- Suharto of Indonesia reveals budget and rupiah plunges to all-time low
- Asia's largest private investment bank in Hong Kong, liquidates due to investments failing in Indonesia
- Suharto signs new loan deal with IMF, agrees to get rid of subsidies and national monopolies - food prices hike by 80%, later reaches third deal where IMF relents on fuel and food subsidies, but Suharto agrees to close finance institutions.
- Japan goes into recession
- Fourth agreement with Indonesia and IMF, Suharto resigns
- DOW jones falls 300 points.
(from http://www.mtholyoke.edu/~rmudbhar/Timeline.html )
A great deal of these problems arose from the mixture of fixed ER, no capital controls and plenty of unhedged short-term capital investment and borrowing, laeding to efforts to defend the currency, current account deficits and eventual currency crisis. The currency crisis was met with and exacerbated a banking crisis. The speculator and investor panic spread to nearby interdependent economies with similar structural characteristics - fixed ER, no capital controls, unhedged short-term capital and borrowing, weak banking sector and crony capitalism with expectation of bail-out and unproductive investments.
Speculation can create enormous pressure on a currency. Bankruptcy protection is provided in local currency. With a bubble of capital inflows that bursts, there is a rapid downturn, interest rates rise, reserves that were spent defending the currency are depleted providing no reserves against bankruptcies. The only choice may be to devalue the currency and break the promise, with fallout as investors lose confidence in that country. This is what happened in Thailand. Since there is no hedging of investments, you have investor panic leading to contagion in similar fixed-currency markets, as with the Asian crisis. This can create volatility that can be felt around the world. The crisis in Thailand was met with a bail-out from the IMF, which imposed tough conditions. High interest rates and the heavy hand of the IMF in forcing closures and restricting the state caused further contraction in the short-run.
There has been plenty of controversy of the events since the crisis and the IMF's involvement. At the end of the day, whether we disagree on whether the degree of pain brought about by contractionary fiscal discipline was necessary or whether it deepened the crisis, the Asian Tigers are in a much stronger position today than they were even before the crisis. It is difficult to second-guess what could have been done better before the crisis as well. Still, anyone who has gone through 80% food price hikes, or lost their job or much more, may still wonder whether it had to be. We all wonder how it can be prevented in the future.
The lessons seem to be that
a) countries level of development of their financial sectors, their fiscal policy in government and their monetary policy may not be ready for globalization in all its forms - namely capital market liberalization. Many have recommended more partial liberalization and more gradual liberalization of capital markets, particularly in regard to short-term capital. Many wonder whether all countries should be more cautious in this regard.
b) improving the level of development in terms of policy means reducing government interference in the economy that leads to crony capitalism and unproductive investments - likely the cause of the stagnation of total factor productivity masked by short-term capital investment, noted by Krugman.
c) Where removing government interference in the banking sector is cast as deregulation, the second problem arises where the private banks have no regulatory framework. The United States is currently struggling with perhaps a too loose regulatory framework for their financial sector which allowed sub-prime mortgages. Still, it had more sound regulation than what occured in the Asian countries after the deregulation. My arguments is that the IMF, in these contexts, should be talking about re-regulation. Regulatory frameworks managed by impersonal management of standard, sound and predictable regulations, enforced on political and economic actors by independent rule of law, is a very different thing than interterference in the economy by regulating by political command - proferring investments to business friends and rescuing them when they fail.
d) Fixed ER regimes do not seem to mix well with no capital controls because of the difficulty in defending against speculative attacks on currency.
e) Despite our lessons on the benefits of free trade outweighing the negatives, and our expectations of rational self-interest in the market benefiting everyone through competition and meritocracy, there is real danger that the incentives for success, if not managed well, create the opportunity for exuberant greed. This exuberant greed creates too much volatitity and distortion to be argued as healthy for productivity as self-interests might be. Greed can manifest where the government's power creates incentives for crony capitalism, but it can also manifest where goverance in a free market is nowhere to be found.
To sum that last point, we need free markets. But zero restrictions and freedom have never lasted together longer than a moment. The long-run freedoms that we gain are through the restrictions that allow us to shape and learn. Capitalism is like a dog, it wants to have no restrictions at first, but is happier when it obeys human beings restrictions because of the predictability, and capitalism wants to serve people. That is the beauty of it, the benefit.
A command economy is like Western classical music, there is a composer whose central plan determines every note the instrumentalist will play. In music fine, in the economy, no freedom and the players curry favour with the conductor.
An unhinged free market is like a drum circle, plenty of herd effects with everyone trying to follow the beat, dominated by a few players who know really know what they are doing, plenty of freedom, but no direction and can end in a cacophany or a monotony.
A freedom market (as I like to call it) is like Indian Classical music. There is a sophisticated set of rules that provide the fit between the music and the mood of people (very important in economics). Freedom takes long years of learning, but the skilled player has immense freedom within a structure. There is form and structure which is barely visible but very influential on creating the right incentives for good playing, but the playing itself is entirely fluid. It is the marriage of static and dynamic – Heraclitus’s stream running over Plato’s forms. It appears entirely spontaneous, and it is, because of the learning created by the restrictions. So states provide structures including impartial restrictions through the rule of law and through incentives that are also impartial and protected from influence.
Restrictions should be provided both for government, which wants to serve people, and for the market. We have to be long-sighted enough and wise enough to want the restrictions that will shape a green economy and human-rights based economy, restrictions both for government and for the market.
The real lesson is that like in previous centuries, where we sought to separate church and state, we now need to separate business and state, with business having private responsibilities within legal bounds, and governments having public responsibilities without interference in private lives. To avoid the crony capitalism, the regulations and action of government must be delivered by impersonal, impartial mechanisms regulating property rights and incentives in the market and protecting the public commons, individual human rights and basic rights by the dictates of legal responsibility. These legal and public mechanisms, even those to do with trade like the WTO, must be protected from capture by private interests, in the same way that a healthy economy must be protected from interference. The portion of private wealth needed to ensure those basic entitlements through public means should be provided as a restriction in the market. This may seem to be conradictory, since the public space and the private space overlap, however it is an ideal which is no more contradictory than the presence of 'freer trade' that still moves us toward non-discriminating free trade even as it creates discrimination. We'll get there, separation of business and state!
The main lesson for me is the separation of business and state.
