The Chastening

by Paul Blustein

  Still, the IMF’s tardiness in dealing with issues such as the deposit guarantee and corporate debt is a subject of considerable ruefulness among its staff. “In hindsight, the [Indonesian] program did not move quickly enough to address the problems of corporate debt,” stated the staff report assessing the three major Asian rescues of 1997-1998. Second-guessing also abounds as to why so much emphasis was placed on detailed anti-KKN reforms. Following a sober reappraisal of this and other cases, the Fund has suggested that in the future its programs will include such structural measures only when they enjoy the heartfelt support of the country and its leaders. In endorsing this new approach, Horst Köhler, Michel Camdessus’s successor as managing director, declared, “I will not have another Indonesia.”

  In any event, after the flameout of the January 15 program, the IMF and Suharto were repeatedly at loggerheads, and the rupiah’s value fluctuated between 7,500 and 15,000 per dollar for weeks. The High Command became increasingly convinced that the aging leader would never abandon the KKN system, a perception that gained force when the Indonesian government issued rules in March and April 1998 circumventing the promises to dismantle the plywood cartel and the clove monopoly.

  Suharto, meanwhile, was flailing around for answers to his country’s problems that transcended the conventional orthodoxy of the IMF. His search for solutions would lead to one of the most curious episodes of the crisis.

  Steve Hanke was in Istanbul, Turkey, delivering economics lectures at Bogazici University in late January 1998 when a fax arrived requesting that he fly to Jakarta. The fax came “from Suharto’s people,” he said, offering no further elaboration.

  A few days later, Hanke, a professor of applied economics at Johns Hopkins University, was in Indonesia for the first time in his life, staying with his wife Liliane at the Shangri-La Hotel under the name “Simon Holland.” Most evenings, he went to Suharto’s home, where the fifty-five-year-old Hanke entranced the aging president with a plan for saving Indonesia’s economy. Word spread swiftly that Suharto had a new dukun, or medicine man, and the pair indeed seemed to be hitting it off. “See, Professor?” the Indonesian strongman chortled one evening, waving a copy of The Asian Wall Street Journal, which carried pictures of both men on the front page. “You’re a crony now.”

  Hanke brimmed with the resentment of a man long treated as a bit of a crank by many of his professional colleagues. A pipe smoker who sported silk ascots and kept half-moon glasses perched on his nose, he had a penchant for hyperbole, exacerbated by his frequent abuse of the word “literally.” In conversations, he sometimes fumed that unless Indonesia adopted the policies he favored, the country was “literally going to blow up” or “literally going to go down the tubes”—conjuring up, albeit unintentionally, images such as a mass eruption among the archipelago’s many volcanoes.

  The policy Hanke championed was a currency board, a monetary system that is analogous to putting an economy—or at least its money supply—on autopilot. A nation that adopts a currency board rigidly pegs its currency to another major currency, usually the U.S. dollar—and the operative word is “rigidly,” because a currency board affords no wiggle room, unlike the more flexible systems that linked the Thai baht and Indonesian rupiah to the dollar prior to their crises. For example, when Argentina established a currency board in 1991, the value of the peso was set at $1 per peso, and if anyone wanted to trade in pesos, the central bank was bound by law to hand over an equal amount of dollars. Further, it was required to back the supply of pesos in circulation with dollars held in its reserves, so the peso supply could increase only if reserves increased. In adopting a currency board, a government essentially admits that it has lost all credibility with financial markets, so to restore faith in its currency, it hands over its monetary controls to a credibility-laden foreigner (in Argentina’s case, Alan Greenspan, the man in charge of the world’s supply of dollars).

  One huge downside—and the main reason few economists share Hanke’s ardor—is that the central bank completely surrenders its power to respond to booms and busts. Even when the economy slumps and Joblessness soars, the monetary authorities can’t pump up the money supply and drive down interest rates if doing so would violate the rules of the currency board.

  In Hanke’s view, such drawbacks amounted to nothing more than minor nuisances. “All these economists who’ve never studied any of these things in depth, and have no historical perspective, and very little empirical perspective, come in here with all the litany of reasons [currency boards] won’t work,” he once told me. “The fact is, they’ve always worked. There are no cases where they haven’t.”

  Indonesian economic policymakers were dumbfounded, and the IMF was alarmed, by Hanke’s sudden emergence as an influential adviser to Suharto, who publicly disclosed his interest in a currency board by declaring on February 9 that “we must quickly fix the currency at a certain rate” (he was widely rumored to be aiming for something like 5,500 per dollar.) The American interloper got a spacious office suite in Bank Indonesia, where he spent his days poring over mounds of monetary data, and he became an instant celebrity on the streets of the capital, with strangers pressing to shake his hand in restaurants. Some evenings, a government car would arrive at the Shangri-La to whisk him to Suharto’s home; other evenings he would go with one of the presidential cronies, usually timber baron Bob Hasan, and there he would discuss the merits of currency boards with Suharto, who spoke English but occasionally relied on an interpreter. “At night was when the real business got done,” Hanke recalled. “About seven, [Suharto] would start, and it was a steady stream of people coming in there. It was obviously very informal, but that was his preference for doing real business. I had complete access to him; I could see him any time I wanted to. It was very worrying for the opposition”—that is, top Indonesian economic policymakers, many of whom didn’t seem to be welcome at Suharto’s soirees.

  Among the items on Hanke’s résumé—about which he said he duly informed Suharto—is the chairmanship of the Friedberg Mercantile Group, a Toronto-based international investment firm that profited from short-selling Southeast Asian currencies, including the rupiah, in 1997. Characteristically, Hanke cited his real-world experience as evidence for his superior insight. “I’m always amused by these economists who never traded a currency in their life telling us how currency markets work,” he said. “I know what I’m doing. I know what causes currencies to blow out and what causes a currency crisis. And I also know what fixes the crisis.”

  The chest-thumping notwithstanding, Hanke could tell a persuasive story about how the success of currency boards had dramatically increased their acceptance among once-disdainful mainstream economists. He first became aware of the idea in autumn 1983 when Hong Kong was stricken by a panic that sent money flying out of the country following China’s indication that it would reclaim the territory from Britain at the end of London’s lease in 1997. The crisis quickly abated when British Prime Minister Margaret Thatcher—whose economic adviser, Alan Walters, was a friend of Hanke’s—established a currency board that locked Hong Kong’s currency irrevocably to America’s, at 7.8 Hong Kong dollars per U.S. dollar.

  Hanke’s enthusiasm grew as he researched the concept, which appealed to his hard-core free market view that governments should restrain themselves as much as possible from economic fine-tuning. He advised Argentina on its currency board and took great pleasure in the speed at which the country recovered from hyperinflation once control over the money supply was effectively removed from politicians’ hands. The Argentine case was followed by several others in which currency boards generated sharply lower inflation and interest rates, including Estonia in 1992, Lithuania in 1994, and Bosnia-Herzogovina and Bulgaria in 1997. In Bulgaria, whose government Hanke also advised, the IMF itself insisted on a currency board as a condition for a loan, much to the satisfaction of Hanke, who felt his crusade was finally starting to win converts in high places.

  But the IMF and the rest
of the High Command viewed Hanke’s proposal for an Indonesian currency board as economic snake oil, as evidenced by the name “Hanky-panky” with which he was derided in some quarters of the U.S. Treasury. Although officials at the Fund and Treasury say they carefully examined the merits of introducing a currency board to steady the rupiah, they concluded that Indonesia was ill-suited for such a plan. “We had a serious discussion about it—it wasn’t treated frivolously—and it turned out we were all pretty strongly against it,” said David Lipton, who tended to be more sympathetic toward unorthodox proposals than were other U.S. officials. “We thought they [Suharto and his inner circle] were grasping for an easy way out that simply didn’t exist, and that they wouldn’t be able to behave in the ways that would be required in order to make a currency board successful.”

  A primary reason it wouldn’t work in Indonesia, IMF and Treasury economists argued, was that Suharto had shown no inclination to restrict the supply of money, as a currency board would require. With the banking system on its knees, they reasoned, the government surely wouldn’t be able to resist the temptation to funnel emergency rupiah loans to cash-starved banks, especially well-connected ones, even though such transactions would be forbidden under a currency board. Another problem was that Indonesia did not hold sufficient reserves of dollars to back the value of all its rupiah.

  Finally, the Fund and Treasury suspected that once the rupiah was fixed at, say, 5,500 per dollar, Suharto’s family and friends would take advantage of the opportunity to spirit their money out of the country at a favorable exchange rate, using their connections to obtain the remaining dollars in the central bank before it ran dry. Although Washington had no evidence suggesting that the currency board would be used for that purpose, U.S. and IMF officials thought the potential for such abuse existed.

  On February 11, Camdessus sent Suharto a private letter warning him against proceeding with Hanke’s plan. The second $3 billion tranche of the Fund’s $10 billion, three-year loan for Indonesia was scheduled for consideration by the Executive Board in mid-March, and Camdessus’s letter left little doubt that a currency board would cause the Fund to cut off money to Jakarta. “[I]f a currency board were adopted, we would not be able to recommend to the IMF Board the continuation of the present program because of the risks to the Indonesian economy,” Camdessus wrote.

  Hanke saw Suharto’s pursuit of a currency board as motivated purely by an understandable desperation to shore up the rupiah—and an understandable displeasure that the IMF’s prescriptions were failing in that regard. In one of their early meetings, he recalled, the Indonesian strongman fretted about the inflation that would likely ignite as the result of the rupiah’s collapse. “He said, ‘They’ll riot in the streets, I’ll have to bring in the military, and it could potentially get quite bloody,’” Hanke said. “He also said he was very worried about radicalization of the Muslims.”

  At first, it appeared as if Suharto might disregard the IMF’s threat. In mid-February, he asked Hanke to draft a comprehensive economic plan, including a currency board, and told him that Indonesia was prepared to throw out the IMF Just as it had thrown out the Dutch colonialists after World War II. Hanke triumphantly reported at the time that Suharto knew “he holds the trump card—because if this thing [Indonesia] goes down the tubes, all of Asia’s going down the tubes.” In other words, the IMF wouldn’t dare pull the plug on Jakarta.

  But the pressure on Suharto was relentless, with frequent phone calls from Clinton, Kohl, and a host of other world leaders warning him to follow the IMF’s counsel to shelve the currency-board plan. Their governments were advancing bilateral loans to Indonesia to help cash-starved Indonesian companies finance their exports and imports, plus shipments of rice to ease a looming famine in Indonesia’s interior, which had been stricken by one of the worst droughts in years. With its hard-currency reserves depleted, the country needed every dollar to ensure that it could buy food from abroad. A furious Hanke concluded that the Clinton administration was trying to get rid of Suharto: Why else would it block a currency board, the only plan that could save his country’s economy and hence his presidency?

  In late February, Indonesian economic policymakers let it be known that the currency-board proposal would be deferred for the time being, and in early March, Suharto said that although he was “carefully and cautiously contemplating” a currency board, “whatever measure we shall take, we need the support of the IMF.” Reduced to working on a plan that never seemed to be getting off the ground, Hanke returned to the United States, still hoping that Suharto would implement his proposal.

  Hanke spoke one last time with Suharto in late April, by phone, from Hong Kong. The Indonesian president told him he would have to abandon the currency board once and for all, because Indonesia simply didn’t have enough dollars in reserve to make it work. Hanke insisted that this should not necessarily prevent a currency board from going forward, because there were ways of launching a board with less than “full coverage,” and he offered to fly to Jakarta immediately to work out the technical details. But Suharto showed no interest in that idea, and—according to Hanke—said “there is another problem,” namely that the U.S. Pacific Fleet had been dispatched to conduct exercises near Indonesia.

  That conversation, of course, reinforced Hanke’s conviction that the United States wanted to see Suharto ousted. Hanke’s logic—that U.S. officials were deliberately blocking the currency board because they knew in their hearts it would work wonders—may have been cockeyed. But his conclusion was not utterly divorced from reality. In fact, some powerful forces in Washington were hoping for a speedy end to the Suharto regime.

  Ever since taking over at the Treasury, Bob Rubin and Larry Summers had exercised significant influence over many foreign policy debates, often to the disgruntlement of the State Department, the Defense Department, and the National Security Council. This was a natural consequence of the end of the Cold War and the priority the Clinton administration attached to economics in its conduct of global affairs. Concerns about missile throw weights and guerrilla insurgencies had lost importance, in relative terms, to matters such as cracking import barriers and generating healthy demand for Jobcreating U.S. exports. So economic agencies such as the Treasury, the U.S. Trade Representative’s office, and even the lowly Commerce Department were assuming far greater roles than before in setting the foreign policy agenda. The Asian crisis in particular had turned Rubin and his Treasury team into heavyweight players on the diplomatic stage, because nobody else in the administration could compete with their grasp of the complex financial issues at stake. The president’s faith in Rubin, moreover, made it extremely daunting for other administration officials to take disputes with the Treasury Secretary to the Oval Office.

  But in Indonesia, Treasury’s intrusion into the foreign policy sphere reached new heights, especially in the months following the failure of the January 15 program, when the rupiah continued to sag and the Indonesian economy imploded. During this period, Rubin and Summers, who had always preached the paramount importance of sensible macroeconomic policies and sound financial fundamentals, concluded that Indonesia’s crisis had so deteriorated that necessary remedies fell far outside the Treasury’s traditional realm of responsibility. “I was astounded,” said Sandra Kristoff, the National Security Council’s chief Asia specialist. “Rubin was saying, ‘I am no longer confident that economic reform alone will work. There has to be political reform as well.’”

  Treasury’s new approach was based on the following rationale: A change in economic policy alone wouldn’t do much to convince investors to bring their money back into the country. Funds would return to Indonesia only if people felt assured that the country afforded a stable long-term environment, both in political and economic terms. The conditions for such stability were obviously not present in a country with a history of violent political transitions and no rule of law, run by a seventy-six-year-old autocrat whose hold on power was looking increasingly shak
y, and with little consensus about the choice of his successor. Some among Rubin’s brain trust were blunt in asserting what all of these concerns really meant—namely, that Indonesia’s current leadership was emerging as the chief obstacle to economic recovery. “I wrote memos saying, ‘As long as Suharto is in charge, this [attempt to restore confidence] is going nowhere,’” said Robert Boorstin, one of the Treasury chief’s counselors.

  Admittedly ignorant about Indonesian politics, Treasury officials consulted outside experts, notably Paul Wolfowitz, a former U.S. ambassador to Jakarta who was dean of the School of Advanced International Studies at Johns Hopkins University—and who happened to be David Lipton’s next-door neighbor. Wolfowitz believed that Indonesia’s political stability depended not only on the question of presidential succession but also on whether the regime could broaden its support sufficiently to unify the country in facing the economic crisis. That meant Suharto had to reach out to some of his internal critics, perhaps even bringing into a new government the leaders of the opposition parties and movements whom the president had previously treated as subversive. The Treasury adopted some of Wolfowitz’s reasoning, arguing that in the absence of political change, further IMF support for Jakarta would simply be wasted. Suharto didn’t appear capable of embracing political reform, as indicated by his backtracking on some of the conditions in the January 15 program. In the Treasury’s view, those seemed poor circumstances under which to continue disbursing the Fund’s money; blithely handing large-scale aid to Suharto would risk further damage to IMF credibility.