The Chastening

by Paul Blustein

  Although he acknowledged that Thailand, Indonesia, and Korea suffered from corruption, poorly supervised banking systems, and crony capitalism, these problems were long-standing and could not explain why so many countries were hit all at once, Sachs contended. He believed the crisis was similar to a bank run in which depositors rush to withdraw their money for fear that no money will be left in the vault. The crisis, he noted, was affecting only those countries that were most susceptible to such runs—countries where foreign bankers and other creditors suddenly woke up to the fact that there wasn’t enough hard-currency reserves to cover all the debts they were owed in the near future. As Sachs wrote in a paper with his colleague Steven Radelet: [T]he crisis is mainly the result of a self-fulfilling panic of creditors. Rational investors may have an incentive to pull money out of an otherwise healthy country if the other investors are doing the same thing. The key analytical question is when such a self-fulfilling panic can occur. In our view, the main condition is a high level of short-term foreign liabilities relative to [hard-currency reserves].

  The crisis hit only countries that were in a vulnerable position, i.e. with high levels of short-term debt relative to [reserves]. No emerging market with low levels of short-term debt relative to reserves was hit, even those with high levels of corruption and weak banking systems.

  The IMF didn’t dispute that panic played an important role in the crisis. But Sachs contended it was such an overwhelming factor that the Fund’s traditional austerity-oriented remedies—budget cuts, tight monetary policy, and so on—would only exacerbate the problem. The impact of the withdrawal of capital, after all, is recessionary, so as Sachs put it, “You don’t need to contract on top of the contraction. Don’t crunch fiscal policy. Don’t send interest rates sky high. It doesn’t restore confidence. It Just makes the crisis worse.”

  What Sachs didn’t know—and couldn’t, because of the IMF’s ironclad internal discipline—was that some of his analysis was echoed, at least to an extent, by Fund economists during internal debates over how to handle the crisis. In Korea, for example, some staffers from the Asia and Pacific Department fought hard against proposals by others in the IMF for sharply higher interest rates, insisting that such a policy would be counterproductive in a country where companies were so highly indebted. Wanda Tseng, cochief of the Seoul mission in November 1997, made such an argument in a high-level meeting some weeks later. One IMF economist recalled her saying, “If you raise interest rates, the corporations will go further into the red. External creditors will be even less willing to lend to Korean banks that are exposed to these corporations and will withdraw dollars even more. So the currency will depreciate further, and you’ll worsen the crisis.” The economist further reported: “Fischer was listening. And it did give people pause.”

  The Fund’s interest-rate hawks conceded that raising borrowing costs would magnify the pain to economies in distress. But they argued that the alternative was worse—a currency plunging completely out of control. Since many Asian borrowers owed debts in dollars, a drastic weakening in the local currency would also cause widespread bankruptcies. So the best policy for a country in crisis, they argued, was to raise interest rates quickly to extremely high levels—upward of 60 percent or even 100 percent, if necessary—and hold them there, in the hope that the currency would soon stabilize. The high rates would provide irresistibly attractive yields for investors of all kinds to keep their money in local currency, and as soon as the panicky sell-off of the currency abated, rates could be eased back down.

  Backing up the hawks were the most influential members of the Executive Board—Karin Lissakers of the United States, together with representatives of Britain, Germany, and other powerful countries. In informal meetings, these board members often berated dovish staff members when they felt interest rates weren’t being raised enough in countries that had sought Fund rescues. (As previously noted, such a clash occurred in Indonesia.) “There were huge fights over monetary policy, partly because of ambivalence on the part of the staff,” Lissakers recalled. “Some people said, if we Jack up interest rates, we’ll kill off companies. But you’re dealing with a foreign exchange crisis. So pick your poison. You’re going to have a terrible problem either way.”

  The IMF’s doves were not as dovish as Sachs would have liked, to be sure. Tseng said she favored higher rates in Korea, Just not as high as the hawks advocated. But some staffers later became bitter over the upbraiding they took for tight-money policies that were a source of much greater contention within the Fund than was known at the time. “On the one hand, we were being clobbered by Jeff Sachs, who was on Mars,” one former IMF economist said. “And the Board was coming from the opposite direction, thinking we are all wimps. The U.S. Treasury guys were incredible hawks, wanting us to raise interest rates sky high. They hid behind our skirt. They were willing to let the Fund get all the blame, and never made it clear that if things were left to them, interest rates would have been raised substantially higher.”

  Regardless of who was responsible for the policies, Sachs contended that he was right to condemn them. The fact that several of the crisis-stricken countries had enjoyed strong recoveries in recent years only strengthened his conviction. “You got a sharp rebound in Asia from mid-1998 onward, and both sides in the debate claim vindication,” Sachs said. “I argued that this was not a crisis of fundamentals; it was a crisis of confidence, and the crisis was so much more extreme than Justified by the fundamentals that when it ended, you would get a sharp bounceback. The IMF says, ‘Look how good we did’—looking, for example, at Korea. But my view is, why did you have to have a recession like that?”

  The scene was the September 1997 annual meeting of the IMF and World Bank in Hong Kong, and Joseph Stiglitz was committing heresy—if not outright sedition.

  Meeting privately with a group of East Asian finance ministers, Stiglitz, the World Bank’s chief economist, was taking a position flagrantly at odds with the IMF’s dogma that supported liberalizing the flow of capital around the globe. The fifty-four-year-old Stiglitz urged the ministers to press ahead with a plan some of them were considering to impose emergency controls on short-term funds flowing in and out of their countries. When the ministers fretted that such an action would draw the opprobrium of the IMF and the financial markets, Stiglitz suggested that they could dampen the impact on their individual economies by acting collectively.

  The plan never came to fruition. But as the story suggests, Stiglitz was not bashful about breaking with his employer’s sister institution. During his tenure at the World Bank, he refrained from using Sachslike purple prose in his public utterances and writings; indeed, he usually avoided mentioning the IMF by name. But he managed to convey, quite publicly, his agreement with Sachs that the crisis was a panic and that the IMF’s austerity programs were making it worse. In a February 1998 speech in Chicago, for example, he derided the use of high interest rates as an inducement for investors to stop withdrawing their money from a crisis-stricken country: “In many circumstances [high rates] will also create financial strains, leading to bankruptcies ... making it less attractive to put money into the country,” he said. His position afforded explosive force to his opinions; if Sachs was an irritant to the IMF, Stiglitz was a bull in the Bretton Woods china shop.

  Bearded, with thinning salt-and-pepper hair and round wirerimmed glasses, Stiglitz had a distinguished academic record that would win him a Nobel Prize in economics in 2001. Tales of his absent-minded-professor ways were legion. His ties were perpetually askew, and he often removed his shoes in the middle of meetings. But despite a twinkly-eyed good humor, he tended to press his arguments in internal debate with such unrelenting ardor as to limit his effectiveness as a policymaker; during his four years on the Council of Economic Advisers, he often exasperated even those who were siding with him, former colleagues recalled.

  In a conversation shortly after he left the World Bank in spring 2000, Stiglitz explained his motivation for going
public against the IMF. “I thought the adverse consequences of the [Fund’s] policies were so great—people actually died,” he said, adding that the IMF refused to respond to his “private, quiet interventions,” so “I felt from a moral point of view, one couldn’t Just remain silent.” Manifesting the fervor that often rubs people the wrong way, he cited a history course his children had taken in which they learned about the Holocaust and the culpability of Germans who failed to speak out. “You have to think about that kind of issue,” he said. “Clearly it was not the same kind of crime. But peoples’ lives were being destroyed, and I believed unnecessarily so.”

  Stiglitz’s battles with the IMF (later recounted in a best-selling book he wrote) were the most visible part of a larger rift between the World Bank and other elements in the High Command. Many World Bankers shared his views on the crisis, and they felt aggrieved because their institution—which, like the IMF, has an Executive Board dominated by the G-7—was being forced to contribute vast sums toward rescue packages as if it were some sort of giant automatic teller machine. World Bank officials recalled James Wolfensohn, its president, railing about “late-night phone calls” from Rubin and Summers, who would typically pressure him by saying they had prepared a package of so many billions of dollars including a portion from the World Bank—and that without the World Bank’s contribution, the entire rescue would fall apart.

  Since the mission of the World Bank is to alleviate poverty, there was a legitimate argument for it to lend money to countries in crisis, for purposes such as helping families keep their children in school. But the demands from the U.S. Treasury, which came with virtually no consultation, left no time for study or planning at an institution that traditionally took months or even years of deliberation before granting a loan. The main motive was clear—to beef up the dollar amount of the packages—so under duress from its main shareholders in the G-7, the World Bank provided the Asian crisis countries with billions of dollars in all-purpose, fast-disbursing “structural adjustment loans,” which soared from 2 percent of its lending in fiscal 1996 to nearly 40 percent in fiscal 1998. “It was in all ways galling,” said one of Wolfensohn’s top aides. “It wasn’t Just that we disagreed with the macro tightness of the Fund packages; it was that our development lending was being diverted into this financial crisis-fighting function.”

  Still, as angry as the World Bankers were, many of them considered Stiglitz a loose cannon. His broadsides often seemed aimed at the World Bank as well as the Fund, notably speeches he gave questioning the “Washington consensus,” the orthodox economic view that countries maximize their chances for prosperity by liberalizing, stabilizing, and privatizing their economies. He spent little time on internal issues and projects and remained distant from most of the staff. “He was playing the outside game, using the bank as a bully pulpit, seeing how far he could go,” said David Ellerman, a close aide to Stiglitz at the World Bank. “In terms of looking at the detailed design of a program, and trying to shape it while it was still in the bank, Joe did very little of that.... He had personal sources of information, like Korean professors he knew, or people who’d been his students, guys who were now chaebol big shots. He almost took it for granted that the information he was getting from the Bank was degraded in some way. So even when he was in the bank, he wasn’t really of the bank.”

  Stiglitz was proud of having been raised in working-class Gary, Indiana, where he went to a public school that taught skills such as printing and electrical work. After graduating from Amherst College and earning his Ph.D. at MIT, he taught at several major universities and ended up at Stanford in 1976. He soon became renowned for his pathbreaking research in a field called the economics of information, which explored how free markets could produce bad outcomes. Challenging the conventional assumption of most economic analysis that the private pursuit of individual gain always maximizes societal welfare, Stiglitz’s work showed that unfettered markets function imperfectly under some circumstances because of the less-than-perfect information available to each participant. Part of his antipathy toward the IMF stemmed from his belief that the Fund had never used his findings in its theories about how economies work. “None of these ideas is incorporated into their model,” he said. “They stopped [updating their model] in 1975.”

  One important paper Stiglitz wrote, for example, demonstrated that high interest rates had a serious, little-noticed downside: Companies suffer severe losses of net worth as they struggle to make interest payments, and once that happens, they find it difficult to recover and issue stock to new investors. Thus the damage from high rates is long-lasting even if the high rates themselves are temporary.

  Stiglitz discussed the implications of his work in summer 1997 with Stan Fischer at a party at the Washington home of Jeffrey Frankel, a member of the Council of Economic Advisers. The two men went outside while other guests remained indoors. “I conveyed the sense I was worried [the IMF] was being excessively contractionary,” Stiglitz recalled, “and Stan conveyed the view that if that turned out to be the case, they would have enough flexibility to adapt”—in other words, the Fund would urge crisis-stricken countries to switch to a more stimulative approach. “I replied that there are long lags and irreversibilities—that is, if you destroy firms, you don’t re-create them.”

  Later, he said, he tried to organize a conference or seminar to which experts would be invited to discuss with IMF and World Bank officials the problems posed by the Fund’s austerity-minded approach. But the IMF rejected the idea after Fischer received a phone call from a reporter asking about it. “I wasn’t willing to have a public event at which Joe expressed his views and others expressed their views and we got this whole thing escalated up,” Fischer said. In a voice at once measured and smoldering, he added:The notion that Joe has—that he was the only voice in the wilderness, and nobody else had thought of all this and that, is Just wrong. Those debates took place, without Joe’s intervention. It could have been done with Joe.

  On the argument that companies go permanently bankrupt because of high interest rates—there is a trade-off. He Just ignores the fact that further devaluation also produces bankruptcies. It’s not as if people at the IMF don’t understand that if you have high interest rates it’s bad for firms.

  There are institutional reasons why you don’t want one Bretton Woods institution criticizing another publicly. I very firmly believe that our institutions stand or fall together. It took a lot to refrain from responding to the World Bank’s attacks, but we did the right thing.

  The phone rang late on Saturday night, September 14, 1997, at the Tokyo home of Eisuke Sakakibara, the Japanese vice minister of finance for international affairs. The caller was Larry Summers, obviously angry and apparently in no mood for conversational niceties. “I thought you were my friend,” he sputtered.

  Sakakibara was no stranger to confrontation with high-ranking officials from Washington, but this time, he was in deep. Four days earlier, he had sent a confidential document to five Asian governments proposing that Japan and its neighbors establish an “Asian Monetary Fund” armed with tens of billions of dollars in hard currency, and now Washington had obtained a copy. For two hours that night, the fifty-six-year-old Sakakibara tried to mollify Summers, without success. As far as his American interlocutor was concerned, Sakakibara’s plan posed a grave danger to the proper functioning of the IMF.

  From his lively attire to his voluble manner and his zest for intellectual combat, Sakakibara was a breed apart from the stereotypically starchy Japanese bureaucrat. In a country whose elite civil service wields legendary control over policy, the ministry he served was the most eminent and powerful of all. The men (and they are almost all men) who staffed its offices were primarily top graduates of Tokyo University’s law department, the pinnacle of achievement in an education system that subjects students to a grueling battery of exams at every step. But in contrast to the formal air that pervaded the ministry, where officials tended to ponder questions
warily and respond with carefully hedged opinions, Sakakibara’s style was to prop his feet up on his desk or coffee table and let fly a stream of provocative statements, interspersed with throaty cackles. Whereas dark suits and white shirts tend to be de rigueur among Japanese bureaucrats, Sakakibara often sported beige suits with green or purple shirts. Flaunting his familiarity with Western culture, he kept vintage wines on display in his office and made frequent references to his extensive experience in the United States, which included a year as a high school exchange student in Pennsylvania, a Ph.D. in economics from the University of Michigan, a spell on the IMF staff, and a visiting professorship at Harvard.

  Yet as un-Japanese as he seemed on the surface, Sakakibara was a passionate nationalist who championed the view that his country must cling to its cultural values and reject the socioeconomic model that Washington tried to press on Tokyo and other Asian nations. The United States, Great Britain, and other individualistic, Anglo-Saxon societies might be ideally suited to the dog-eat-dog world of creative destruction in which the forces of the profit motive constantly eradicate weak enterprises and spawn vigorous ones. But that was decidedly not true of Japan, in Sakakibara’s view, because of the importance Japanese attached to social harmony and the group rather than the rights of the individual.

  Sakakibara’s distaste for the untrammeled free market shone through in a book published in 1990, Beyond Capitalism, in which he made the case that Japan’s “non-capitalist market economy” was perfectly designed to sustain the country’s prosperity while preserving its social fabric. Although Japanese corporate executives competed fiercely to win customers by providing high-quality products and service, they didn’t have to worry nearly as much as their American counterparts about pressure from shareholders for short-term profits, because the bulk of their companies’ shares were typically owned by other companies belonging to the same corporate family, called a keiretsu. Accordingly, Japanese companies could put top priority on maintaining lifetime employment, which in turn elicited profound loyalty and dedication from their employees. As Sakakibara put it, Japan was “anthropocentrist”—meaning that instead of having people serve the interest of capital, the state made sure that capital was marshaled to serve the interests of the people.