The Accidental Theorist: And Other Dispatches from the Dismal Science

by Paul Krugman

  The funny thing about the Sumitomo affair is that if you ignore the exotic trimmings—the Japanese names, the Chinese connection—it’s a story right out of the robber-baron era, the days of Jay Gould and Jim Fisk. There has been a worldwide rush to deregulate financial markets, to bring back the good old days of the nineteenth century when investors were free to make money however they saw fit. Maybe the Sumitomo affair will remind us that not all the profitable things unfettered investors can do with their money are socially productive; maybe it will even remind us why we regulated financial markets in the first place.

  The Tequila Effect

  Relations between Mexico and the United States are not what they were in the early 1990s. In the eyes of many Americans, Mexico is a corrupt nation ruled by drug lords and wracked by economic crisis. In the eyes of many Mexicans, the United States is simultaneously tyrannical and self-indulgent, imposing harsh economic medicine on its neighbor while blaming it for a drug trade that is really our own fault. The voters who turned on the ruling party in Mexico’s 1997 elections were also, at least in part, showing their displeasure for a government too close to the United States.

  And yet things could easily have been much worse. In particular, if Bill Clinton hadn’t done the right thing early in 1995, Mexico’s economy could have imploded, ending forever the hope of reform in that long-suffering nation.

  In the months after the crushing Republican victory in the 1994 Congressional elections, much of the Clinton administration’s inner circle was still in a state of stunned stupor. Yet in those dark days a handful of officials persuaded Clinton to support a daring, risky, and extremely unpopular policy initiative: the rescue, with a huge loan, of Mexico’s collapsing economy. Had that initiative failed, it might well have doomed Clinton’s presidency and much more besides. But it succeeded, and history may record the decision to go ahead with their plan as Clinton’s finest hour.

  In the early 1990s Mexico was the darling of international investors, who were convinced that the economic reforms of then-president Carlos Salinas would produce robust economic growth. The warnings of a few economists that the hype about Mexican prospects was not matched by actual performance were ignored, and money poured in at the rate of $30 billion a year. But over the course of 1994 a series of disturbing news items—a peasant rebellion, the assassination of a presidential candidate, and some bad economic statistics—made the markets increasingly nervous. Finally, in December, the number of fidgety investors reached critical mass, and there was a full-blown run on the Mexican peso.

  So far this is not too unusual a story; currency crises are actually quite common, and often do little long-run harm. But it soon became apparent that Mexico was different: Having placed the nation on a pedestal for several years, investors were shocked—shocked!—to discover that the country was not a combination of Singapore and Switzerland, and began pulling their money out as blindly as they had put it in.

  The exact details of what happened next are not a matter of public record. But it seems clear that the key figure was Treasury Undersecretary (now Deputy Secretary) Lawrence Summers, a former Harvard professor who has emerged as the economic brains of the Clinton administration. Summers reached two conclusions about Mexico’s crisis: that there was a chance that American intervention could make the difference between recovery and catastrophe, and that this chance was worth taking.

  What Summers and others at the Treasury realized was that Mexico was plunging into a sort of political-economic death spiral. The panic of investors could not be rationalized by the weakness of the economy alone: What was driving money out of Mexico was political fear, the concern that Mexico’s recent openness to foreign capital and foreign goods might be about to be reversed, that the country might revert to a populist anti-Americanism. The capital flight inspired by this fear was causing a disastrous business slump. And it was this slump that, in turn, was the most powerful cause of political unrest. In short, there was every prospect that pesssimism about Mexico’s future could turn into a self-fulfilling prophecy.

  The answer, as they saw it, was to give Mexico a bit of breathing room: to lend the Mexican government some money, allowing it to stay afloat and to cushion the blows falling on the private sector. If all went well this would in turn give private investors a chance to recover their nerve, and the vicious circle of decline would turn into a virtuous circle of recovery. Of course if all did not go well, the loan might not be repaid. And then there would be hell to pay. Mexico is not a small country, and a loan would do no good unless it was big enough to matter; in the event, the United States and other countries (whose elbows still hurt from the twisting we gave them) provided a credit line of $50 billion. Just imagine the public reaction if any substantial fraction of that money had been lost!

  Why, then, take such a huge risk? Because Mexico is not just any country. Not only does it share a 2,000-mile border with the United States, it is a traditionally difficult neighbor which at the moment happens to be ruled by U.S.-educated technocrats, but whose friendliness can never be taken for granted. To have “our guys” preside over an economic collapse, as seemed all too likely in early 1995, would have been a major foreign policy disaster. There was also, to be frank, the question of protecting the large sums of private money already invested in Mexico; but it is possible to be too cynical. For what it is worth, my sources say that foreign policy, not the interests of Rubin’s Wall Street friends, was the decisive concern.

  And so one winter day Rubin and Summers marched into the Oval Office with their plan—and, incredibly, Clinton agreed. Lending taxpayers’ money to Mexico when private investors were pulling out was not a popular idea. In fact, it quickly became clear that Congress would not allocate the necessary funds; instead the Treasury engaged in some fancy footwork, exploiting a legal loophole to lend Mexico the money without Congressional approval. Furious Republicans, led by Senator Alfonse D’Amato, denounced the plan, and prepared to hang Summers from the rafters when the rescue failed.

  But the rescue did not fail. Mexico’s economy, after plunging 10 percent in the first year after the crisis, has recovered the lost ground. Private investors have returned, stabilizing the peso; and the Mexican government, years ahead of schedule, has repaid that emergency loan. Mexico is not yet completely out of the woods, but U.S. taxpayers are.

  So what are the morals of the story? One is that sometimes it pays to listen to the experts: many people find arrogant technocrats like Larry Summers annoying, but smart is as smart does—and he did. The other is that sometimes it actually pays to do the unpopular thing: If Clinton had listened to the polls that winter day, Mexico would probably be a basket case—and Bob Dole would probably be president.

  Bahtulism: Who Poisoned Asia’s Currency Markets?

  Currency-crisis connoisseurs cherish the memory of George Brown, Britain’s Secretary of Economic Affairs in the mid-1960s—the man who blamed his troubles on the “gnomes of Zurich.” (He was misinformed: the relevant gnomes are actually in Basel.) But we may have to remove Brown from his pedestal, to make room for Malaysian Prime Minister Mahathir Mohamad. Last month Malaysia’s neighbor Thailand, after months of promising that it wouldn’t, devalued the baht, and spooked investors began selling Malyasian ringgit (and Philippine pesos, Indonesian rupiahs, and so on) as well. This provoked an outburst on Mahathir’s part that surely counts as an instant classic. Where Brown was vague about both the identity of the villains and their motives, Mahathir had a full-fledged conspiracy theory: The U.S. government had prompted palindromic speculator George Soros to undermine Asia’s economies, because it wants to impose Western values (like democracy and civil rights) on them. And Mahathir’s ministers expanded on his remarks with a rhetoric that was unusual for a government with a long-term interest in maintaining the goodwill of international investors: Currency fluctuations are caused by “hostile elements bent on…unholy actions” that constitute “villainous acts of sabotage” and “the height of international crimi
nality.”

  These remarks were entertaining both because, as far as we can tell, Soros was not a major player in the crisis (indeed, he seems to have taken a bit of a bath by failing to anticipate this one), and because in the early 1990s one of the world’s most ambitious and reckless currency speculators was…Malaysia’s government-controlled central bank, which only got out of the business after losing nearly $6 billion.

  Currency crises often provoke hysterical reactions in government officials. One day your country’s economy is humming along nicely, your bonds are AAA, you have billions of dollars in foreign exchange reserves socked away. Then all of a sudden the reserves are depleted, nobody will buy your paper, and you can only keep money in the country by raising interest rates to recession-inducing levels. How can things go wrong so fast?

  The standard response of economists is that to blame the financial markets in such a situation is to shoot the messenger, that a crisis is simply the market’s way of telling a government that its policies aren’t sustainable. You may wonder at the abruptness with which that message is delivered. But that, says the canonical model, is simply part of the logic of the situation.

  To see why, forget about currencies for a minute, and imagine a government trying to stabilize the price of some commodity, such as gold. The government can do this, at least for a while, if it starts with a sufficiently large stockpile of the stuff: All it has to do is sell some of its hoard whenever the price threatens to rise about the target level.

  Now suppose that this stockpile is gradually dwindling over time, so that far-sighted speculators can foresee the day—perhaps many years distant—when it will be exhausted. They will realize that this offers them an opportunity. Once the government has exhausted its stockpile, it can no longer stabilize the price—which will therefore shoot up. All they have to do, then, is to buy some of the stuff a little while before the reserves are gone, then resell it at a large capital gain.

  But these speculative purchases of gold or whatever will accelerate the exhaustion of the stockpile, bringing the day of reckoning closer. So the smart speculators will try to get ahead of the crowd, buying earlier—and thereby running down the stocks even sooner, leading to still earlier purchases…. The result is while the government’s stockpile may decline only gradually for a long time, when it falls below some critical point all hell suddenly—and predictably—breaks loose (as actually happened in the gold market during 1969).

  With a bit of imagination this same story can be applied to currency crises. Imagine a government that is trying to support the dollar value of the ringgit—or, what is the same thing, to keep a lid on the price of a dollar measured in ringgit—through foreign exchange market “intervention,” which basically means selling dollars to keep their ringgit price down. And suppose the government’s policies are, for whatever reason, inconsistent with keeping the exchange rate fixed forever. Then there is a complete parallel with the previous story, with foreign exchange reserves taking on the role of the gold stockpile. And by the same logic as before, we can conclude that speculators will not wait for events to take their course: At some critical moment they will all move in at once—and billions of dollars in reserves may vanish in days, even hours.

  The abruptness of a currency crisis, then, does not mean that it strikes out of a clear blue sky. In the standard economic model, the real villain is the inconsistency of the government’s own policies.

  Is Mahathir’s complaint therefore unadulterated nonsense? No: As Art Buchwald once said of his own writing, it is adulterated nonsense. The truth is that speculators may not always be quite as blameless as the standard model would have it.

  For one thing, markets aren’t always cool, calm, and collected. There is abundant evidence that financial markets are subject to occasional bouts of what is known technically as “herding”: Everyone sells because everyone else is selling. This may happen because individual investors are irrational; it may also happen because so much of the world’s money is controlled by fund managers who will not be blamed if they do what everyone else is doing. One consequence of herding, however, is that a country’s currency may be subjected to an unjustified selling frenzy.

  It is also true that the long-run sustainability of a country’s policies is to some extent a matter of opinion—and that policies that might have worked out given time may be abandoned in the face of market pressures. This leads to the possibility of self-fulfilling prophecies—for example, a competent finance minister may be fired because of a currency crisis, and the irresponsible policies of his successor end up ratifying the market’s bad opinion of the country.

  All of this, in turn, creates a possible way for private investors with big enough resources to play a nefarious financial game. Here’s how it would work, in theory: Suppose that a country’s currency is in a somewhat ambiguous situation—its current value might be sustainable, or it might not. A big investor quietly takes a short position in that country’s currency—that is, he borrows money in pounds, or baht, or ringgit, and invests the money in some other country. Once he has a big enough position, he begins ostentatiously selling the target currency, gives interviews to the Financial Times about how he thinks it is vulnerable, and so on; and with luck provokes a run on the currency by other investors, forcing a devaluation that immediately reduces the value of those carefully acquired debts, but not the value of the matching assets, leaving him hundreds of millions of dollars richer.

  Speculative sharp practice, in short, can play a role in destabilizing currencies. But how important is that role in reality?

  Well, George Soros pulled the trick off in Britain in 1992; but as far as anyone knows even he has done it only once. True, it was an amazing coup: He is supposed to have made more than a billion dollars. It’s also true, however, that there were good reasons for the pound’s devaluation, and it is unclear whether Soros really caused the crisis or was merely smart enough to anticipate it. Maybe he brought it on a few weeks early.

  The other currency crises of the nineties—and it has been a great decade for such crises—have taken place without the help of sinister financial masterminds. This is no accident; opportunities like the one Soros discovered in 1992 are rare. They require that a country’s currency be clearly vulnerable, but not yet under attack—a narrow window at best, since there is a sort of Murphy’s Law in these things: If something can go wrong with a currency, it usually will. Financial markets are not in the habit of giving countries the benefit of the doubt.

  Does this mean that there is no defense against speculative attack? Not at all. In fact, there are two very effective ways to prevent runs on your currency. One—call it the “benign neglect” strategy—is simply to deny speculators a fixed target. Speculators can’t make an easy profit betting against the U.S. dollar, because the U.S. government doesn’t try to defend any particular exchange rate—which means that any obvious downside risk is already reflected in the price, and on any given day the dollar is as likely to go up as down. The other—call it the “Caesar’s wife” strategy—is to make very sure that your commitment to a particular exchange rate is credible. Nobody attacks the guilder, because the Dutch clearly have both the capability and the intention of keeping it pegged to the German mark.

  Oh yes—there is also a third option. You can erect elaborate regulations to keep people from moving money out of your country. Of course, if investors know that it will be hard to get money out, they will be reluctant to put it in to begin with. There is a case to be made—an unfashionable case, but not a totally crazy one—that it is worth forgoing the benefits of capital inflows in order to avoid the risk of capital outflows. But Asian leaders uttered not a word of complaint when they were receiving huge inflows of money, much of it going to dubious real estate ventures; only when irrational exuberance turned into probably rational skittishness did the accusations begin.

  So Mahathir’s claims that he is the victim of an American conspiracy are just plain silly. He has nobody but
himself to blame for his difficulties. Or at least that’s what George, Bob, and Madeleine told me to say.

  A Note on Currency Crises

  I often run into people who assert confidently that massive speculative attacks on currencies like the British pound in 1992, the Mexican peso in 1994–1995, and the Thai baht in 1997 prove that we are in a new world in which computerized trading, satellite hookups, and all that, mean that old economic rules, and conventional economic theory, no longer apply. (One physicist insisted that the economy has “gone nonlinear,” and is now governed by chaos theory.) But the truth is that currency crises are old hat; the travails of the French franc in the twenties were thoroughly modern, and the speculative attacks that brought down the Bretton Woods system of exchange rates in the early seventies were almost as big compared with the size of the economies involved as the biggest recent blowouts. And currency crises have been a favorite topic of international financial economists ever since the 1970s. In fact, it is one of my favorite topics—after all, I helped found the field.

  The standard economic model of currency crises had its genesis in a brilliant mid-seventies analysis of the gold market by Dale Henderson and Steve Salant, two economists at the Federal Reserve. They showed that abrupt speculative attacks, which would almost instantly wipe out the government’s stockpile, were a natural consequence of typical price stabilization schemes. In 1977 I was an intern at the Fed, and realized that Salant and Henderson’s story could, with some reinterpretation, be applied to currency crises that suddenly wipe out the government’s reserves. A bit later Robert Flood, now at the IMF, and Peter Garber of Brown produced the canonical version of that conventional story.