Lessons from the East Asia crisisfor Economic Theory

Tokyo

December 2000

Lessons depend on:

– Analysis of causes

– Assessment of impacts of responses

– In light of an appraisal of recovery

Causes

• Critical role played by capital market regulation

• Without an adequate financial regulatory system

• Leaving countries vulnerable to highly volatile movements in short term capital flows, including refusals of banks to roll-over loans

In each country, special features played a role

• Excessive leverage in Korea

• Overvalued exchange rate in Thailand

• Political problems in Indonesia

Other Causes• Lack of transparency, corruption probably played

secondary role, at most– Last set of crises in Scandinavia, most transparent countries,

clearly transparency doesn't inoculate one against a crisis– Marginal lending in Korea by western banks, can't attribute

lending to crony capitalism– May have had adverse effect on efficiency, but issue is one

of "vulnerability to crisis"

• Fixed exchange rate system– Flexible exchange rate in Thailand would have led to

appreciation earlier, even greater fall in exchange rate?– But does point to challenges facing small countries with

multiple trading partners, given high volatility of major exchange rates

Assessment of Responses and Appraisal of Recovery

• IMF packages did not work• Excessively contractionary fiscal policies

contributed to magnitude and duration of downturn• Imposing huge costs on innocent bystanders• While money was used to bail-out international

creditors• Attempt at restructuring financial system in

Indonesia led to runs, further undermining economy• Political and social turmoil deepened problem in

Indonesia

Interpreting the Recovery• Victory claimed too early: what matters is incomes and

wages, not exchange rates and interest rates• Every downturn comes to an end; question is did

policies make downturn longer lived and deeper than necessary--unambiguous answer--yes

• Comparison of countries lays bear claim that IMF policies were responsible for recovery– Malaysia--no IMF program, quickest recovery, with smallest

legacy of national debt– Thailand--best IMF student, GDP just recovering to 1997

levels, huge levels of non-performing loans– Indonesia--still in recession, political and social turmoil to

which IMF policies contributed greatly will make recovery slow

Korea

• Korea--success largely based on deviations from IMF policies– Recapitalizing major banks, rather than shutting

them down– Not shedding excess capacity in chip industry– Active role of government in financial

restructuring (contrast to Thailand)

Lessons

• Many of lessons were already part of "modern" economics

– But importance not fully appreciated

– And not fully reflected in old models used by IMF and others

Lesson 1: Tribute to Standard Macro-Economic Wisdom• Expansionary fiscal and monetary policy in face of

downturn– Contrast china's success in managing way through downturn

• Pay attention to lags • In contrast to psycho-babble "restore confidence"

– Best way of restoring confidence is to have strong economy

– Economists are not good at arm-chair market psychology

– No such thing as “Mr. Market"

– Capital flight of those inside country played large role

– Washington international bureaucrats had little insight into their psychology

Lesson 2: Finance Matters

• Integration of finance into economics represents one of major advances in economic theory of last twenty five years– Finance is about "information"; financial

economics can be thought of as a branch of "information economics"

• Key issue in response is maintaining credit flows--Korea did this, Indonesia did not

Lesson 3: To work effectively, financial markets need strong regulation

• Financial markets are different from ordinary markets (steel, autos)

• IMF pushed policies for deregulation, or focusing simply on capital adequacy ratios, were misguided: issue is right regulatory structure

• Capital market liberalization exposes countries (especially small developing countries) to high risks, with little evidence of benefits in terms of growth

Lesson 4: Bankruptcy plays a central role in modern capitalism

• Worry about default motivated refusal to roll over loans

• Bankruptcy concerns particularly important with highly levered firms

• Increasing interest rates failed to attract additional funds, stabilize exchange rates because it increased probability of bankruptcy, making it less, not more, attractive to put money into these countries and inducing further capital flight

• Need stronger bankruptcy codes to deal with systemic bankruptcy

Lesson 5: Supply side effects are as important as demand side effects

• Exports failed to respond in way predicted--related to lack of credit

Lesson 6: Beggar-thy-self policies are as dangerous as beggar-thy-neighbor policies

• Or more simply: pay attention to trade inter-linkages, not just "psychological inter-linkages"

Lesson 7: Asymmetries matter (hysterisis effects): it is easier to destroy firms than to recreate them  

• Raising interest rates pushed many firms into bankruptcy

 

• Once there, lowering interest rates does not pull them out

Lesson 8: "fallacy of composition"

• Or pay attention to general equilibrium

• How you respond to one failing institution should differ from how one responds when there is systemic failure

• How you respond to one firm going bankrupt should differ from how one responds when there is systemic bankruptcy

Lesson 9: One cannot fully separate economic analysis from political analysis

• Political and social turmoil in Indonesia determining factor

• Turmoil was predictable (and predicted) outcome of policies IMF was pushing

Lesson 10: Needs to subject international financial institutions to same kind of political/incentive analysis as other private and public sector bodies

• What were the incentives of the organization?

• What were the incentives of the individuals within the organization?

• What is the relationship between governance and observed behavior?

Key Questions• How did IMF change from an institution meant to

encourage global economic stability, through putting pressure on countries to maintain full employment and providing liquidity in the event of a crisis?

• Why did IMF become the "bill collector" of the advanced industrial countries, putting pressure on countries to adopt contractionary policies in the face of a downturn, and making that a condition for providing liquidity?

• Why did IMF push for capital market liberalization which has contributed to global economic instability, rather than for structural reforms, like bankruptcy codes, that would enhance stability?

Answers

• Governance– Control by creditor countries– Control by finance ministries--linked to

financial markets

• Operating behind closed doors– Lack of transparency – Insulated from broader accountability