Globalization and Its Discontents Revisited
Page 28
As the crisis progressed, unemployment soared, GDP plummeted, banks closed. The unemployment rate was up fourfold in Korea, threefold in Thailand, tenfold in Indonesia. In Indonesia, almost 15 percent of males working in 1997 had lost their jobs by August 1998, and the economic devastation was even worse in the urban areas of the main island, Java. In South Korea, urban poverty almost tripled, with almost a quarter of the population falling into poverty; in Indonesia, poverty doubled. In some countries, like Thailand, people thrown out of jobs in the cities could return to their rural homes. However, this put increasing pressure on those in the rural sector. In 1998, GDP in Indonesia fell by 13.1 percent, in Korea by 6.7 percent, and in Thailand by 10.8 percent. Three years after the crisis, Indonesia’s GDP was still 7.5 percent below that before the crisis, Thailand’s 2.3 percent lower.
In some cases, fortunately, outcomes were less bleak than was widely anticipated. Communities in Thailand worked together to ensure that their children’s education was not interrupted, with people voluntarily contributing to help keep their neighbors’ kids in school. They also made sure that everyone had enough food, and because of this the incidence of malnutrition did not increase. In Indonesia, a World Bank program seemed to succeed in arresting the anticipated adverse effects on education. It was poor urban workers—hardly well off by any standards—who were made most destitute by the crisis. The usurious interest rates which threw small businesses into bankruptcy contributed to the erosion of the middle class, and will have the longest lasting effects on the social, political, and economic life of the region.
Deteriorating conditions in one country helped bring down its neighbors. The slowdown in the region had global repercussions: global economic growth slowed, and with the slowing of global growth, commodity prices fell. From Russia to Nigeria, the many emerging countries that depended on natural resources were in deep, deep trouble. As investors who had risked their money in these countries saw their wealth plummeting, and as their bankers called in their loans, they had to cut back their investments in other emerging markets. Brazil, dependent neither on oil nor on trade with the countries in deep trouble, with economic features far different from these countries, was brought into the unfolding global financial crisis by the generalized fear of foreign investors and the retrenchment in their lending. Eventually, almost every emerging market, even Argentina, which the IMF had long held up as the poster child of reform, largely for its success in bringing down inflation, was affected.
HOW IMF/U.S. TREASURY POLICIES LED TO THE CRISIS
The disturbances capped a half decade of an American-led global triumph of market economics following the end of the Cold War. This period saw international attention focus on newly emerging markets, from East Asia to Latin America, and from Russia to India. Investors saw these countries as a paradise of high returns and seemingly low risk. In the short space of seven years, private capital flows from the developed to the less developed countries increased sevenfold while public flows (foreign aid) stayed steady.6
International bankers and politicians were confident that this was the dawn of a new era. The IMF and the U.S. Treasury believed, or at least argued, that full capital account liberalization would help the region grow even faster. The countries in East Asia had no need for additional capital, given their high savings rate, but still capital account liberalization was pushed on these countries in the late 1980s and early 1990s. I believe that capital account liberalization was the single most important factor leading to the crisis. I have come to this conclusion not just by carefully looking at what happened in the region, but by looking at what happened in the almost one hundred other economic crises of the last quarter century. Because economic crises have become more frequent (and deeper), there is now a wealth of data through which one can analyze the factors contributing to crises.7 It has also become increasingly clear that all too often capital account liberalization represents risk without a reward. Even when countries have strong banks, a mature stock market, and other institutions that many of the Asian countries did not have, it can impose enormous risks.
Probably no country could have withstood the sudden change in investor sentiment, a sentiment that reversed this huge inflow to a huge outflow as investors, both foreign and domestic, put their funds elsewhere. Inevitably, such large reversals would precipitate a crisis, a recession, or worse. In the case of Thailand, this reversal amounted to 7.9 percent of GDP in 1997, 12.3 percent of GDP in 1998, and 7 percent of GDP in the first half of 1999. It would be equivalent to a reversal in capital flows for the United States of an average $765 billion per year between 1997 and 1999. While developing countries’ ability to withstand the reversal was weak, so too was their ability to cope with the consequences of a major downturn. Their remarkable economic performance—no major economic recession in three decades—meant that the East Asian countries had not developed unemployment insurance schemes. But even had they turned their mind to the task, it would not have been easy: in the United States, unemployment insurance for those who are self-employed in agriculture is far from adequate, and this is precisely the sector that dominates in the developing world.
The complaint against the IMF, however, runs deeper: it is not just that the Fund pushed the liberalization policies which led to the crisis, but that they pushed these policies even though there was little evidence that such policies promoted growth, and there was ample evidence that they imposed huge risks on developing countries.
Here was a true irony—if such a gentle word can be used. In October 1997, at the very beginning of the crisis, the Fund was advocating the expansion of precisely those polices which underlay the increasing frequency of crises. As an academic, I was shocked that the IMF and the U.S. Treasury would push this agenda with such force, in the face of a virtual absence of theory and evidence suggesting that it was in the economic interests of either the developing countries or global economic stability—and in the presence of evidence to the contrary. Surely, one might have argued, there must be some basis for their position, beyond serving the naked self-interest of financial markets, which saw capital market liberalization as just another form of market access—more markets in which to make more money. Recognizing that East Asia had little need for additional capital, the advocates of capital market liberalization came up with an argument that even at the time I thought was unconvincing, but in retrospect looks particularly strange—that it would enhance the countries’ economic stability! This was to be achieved by allowing greater diversification of sources of funding.8 It is hard to believe that these advocates had not seen the data that showed that capital flows were pro-cyclical. That is to say that capital flows out of a country in a recession, precisely when the country needs it most, and flows in during a boom, exacerbating inflationary pressures. Sure enough, just at the time the countries needed outside funds, the bankers asked for their money back.
Capital market liberalization made the developing countries subject to both the rational and the irrational whims of the investor community, to their irrational exuberance and pessimism. Keynes was well aware of the often seemingly irrational changes in sentiments. In The General Theory of Employment, Interest and Money (1935), he referred to these huge and often inexplicable swings in moods as “animal spirits.” Nowhere were these spirits more evident than in East Asia. Slightly before the crisis, Thai bonds paid only 0.85 percent higher interest than the safest bonds in the world, that is, they were regarded as extremely safe. A short while later, the risk premium on Thai bonds had soared.
There was a second, hardly more credible argument that the advocates of capital market liberalization put forward—again without evidence. They contended that capital market controls impeded economic efficiency and that, as a result, countries would grow better without these controls. Thailand provides a case in point for why this argument was so flawed. Before liberalization, Thailand had severe limitations on the extent to which banks could lend for speculative real estate. It had imposed these
limits because it was a poor country that wanted to grow, and it believed that investing the country’s scarce capital in manufacturing would both create jobs and enhance growth. It also knew that throughout the world, speculative real estate lending is a major source of economic instability. This type of lending gives rise to bubbles (the soaring of prices as investors clamor to reap the gain from the seeming boom in the sector); these bubbles always burst; and when they do, the economy crashes. The pattern is familiar, and was the same in Bangkok as it was in Houston: as real estate prices rise, banks feel they can lend more on the basis of the collateral; as investors see prices going up, they want to get in on the game before it’s too late—and the bankers give them the money to do it. Real estate developers see quick profits by putting up new buildings, until excess capacity results. The developers can’t rent their space, they default on their loans, and the bubble bursts.
The IMF, however, contended that the kinds of restraints that Thailand had imposed to prevent a crisis interfered with the efficient market allocation of resources. If the market says, build office buildings, commercial construction must be the highest return activity. If the market says, as it effectively did after liberalization, build empty office buildings, then so be it; again, according to IMF logic, the market must know best. While Thailand was desperate for more public investment to strengthen its infrastructure and relatively weak secondary and university education systems, billions were squandered on commercial real estate. These buildings remain empty today, testimony to the risks posed by excessive market exuberance and the pervasive market failures that can arise in the presence of inadequate government regulation of financial institutions.9
The IMF, of course, was not alone in pushing for liberalization. The U.S. Treasury, which, as the IMF’s largest shareholder and the only one with veto power has a large role in determining IMF policies, pushed liberalization too.
I was in President Clinton’s Council of Economic Advisers in 1993 when South Korea’s trade relations with the United States came up for discussion. The negotiations included a host of minor issues—such as opening up South Korea’s markets to American sausages—and the important issue of financial and capital market liberalization. For three decades, Korea enjoyed remarkable economic growth without significant international investment. Growth had come based on the nation’s own savings and on its own firms managed by its own people. It did not need Western funds and had demonstrated an alternative route for the importation of modern technology and market access. While its neighbors, Singapore and Malaysia, had invited in multinational companies, South Korea had created its own enterprises. Through good products and aggressive marketing, South Korean companies had sold their goods around the world. South Korea recognized that continued growth and integration in the global markets would require some liberalization, or deregulation, in the way its financial and capital markets were run. South Korea was also aware of the dangers of poor deregulation: it had seen what happened in the United States, where deregulation had culminated in the 1980s savings-and-loan debacle. In response, South Korea had carefully charted out a path of liberalization. This path was too slow for Wall Street, which saw profitable opportunities and did not want to wait. While Wall Streeters defended the principles of free markets and a limited role for government, they were not above asking help from government to push their agenda for them. And as we shall see, the Treasury Department responded with force.
At the Council of Economic Advisers we weren’t convinced that South Korean liberalization was an issue of U.S. national interest, though obviously it would help the special interests of Wall Street. Also we were worried about the effect it would have on global stability. We wrote a memorandum, or “think piece,” to lay out the issues, stimulate a debate, and help focus attention on the matter. We prepared a set of criteria for evaluating which market-opening measures are most vital to U.S. national interests. We argued for a system of prioritization. Many forms of “market access” are of little benefit to the United States. While some specific groups might benefit a great deal, the country as a whole would gain little. Without prioritization, there was a risk of what happened during the previous Bush administration: one of the supposedly great achievements in opening up Japan’s market was that Toys “R” Us could sell Chinese toys to Japanese children—good for Japanese children and Chinese workers, but of little benefit to America. Though it is hard to believe that such a mild-mannered proposal could be greeted with objections, it was. Lawrence Summers, at the time undersecretary of the Treasury, adamantly opposed the exercise, saying such prioritization was unnecessary. It was the responsibility of the National Economic Council (NEC) to coordinate economic policy, to balance the economic analysis of the Council of Economic Advisers with the political pressures that were reflected in the various agencies, and decide what issues to take to the president for final decision.
The NEC, then headed by Robert Rubin, decided the issue was of insufficient importance to be brought to the president for consideration. The real reason for the opposition was only too transparent. Forcing Korea to liberalize faster would not create many jobs in America, nor would it likely lead to significant increases in American GDP. Any system of prioritization would therefore not put these measures high on the agenda.10 But worse, it was not even clear that the United States would, as a whole, even benefit, and it was clear that Korea might in fact be worse off. The U.S. Treasury, which argued to the contrary both that it was important for the United States and that it would not lead to instability, prevailed. In the final analysis, such matters are the Department of the Treasury’s province, and it would be unusual for the position of the Treasury to be overridden. The fact that the debate was conducted behind closed doors meant that other voices could not be heard; perhaps if they had, if there had been more transparency in American decision making, it is possible that the outcome might have been different. Instead, Treasury won, and the United States, Korea, and the global economy lost. Treasury would probably claim that the liberalization itself was not at fault; the problem was that liberalization was done in the wrong way. But that was precisely one of the points that the Council of Economic Advisers raised: It was very likely that a quick liberalization would be done poorly.
THE FIRST ROUND OF MISTAKES
There is little doubt that IMF and Treasury policies contributed to an environment that enhanced the likelihood of a crisis by encouraging, in some cases insisting on, an unwarrantedly rapid pace toward financial and capital market liberalization. However, the IMF and Treasury made their most profound mistakes in their initial response to the crisis. Of the many failures outlined below, today there is widespread agreement on all but the criticism of IMF monetary policy.
At the onset, the IMF seemed to have misdiagnosed the problem. It had handled crises in Latin America, caused by profligate government spending and loose monetary policies that led to huge deficits and high inflation; and while it may not have handled those crises well—the region experienced a decade of stagnation after the so-called successful IMF programs, and even the creditors had eventually to absorb large losses—it at least had a game plan that had a certain coherency. East Asia was vastly different from Latin America; governments had surpluses and the economy enjoyed low inflation, but corporations were deeply indebted.
The diagnosis made a difference for two reasons. First, in the highly inflationary environment of Latin America, what was needed was a decrease in the excess demand. Given the impending recession in East Asia, the problem was not excess demand but insufficient demand. Dampening demand could only make matters worse.
Second, if firms have a low level of indebtedness, high interest rates, while painful, can still be absorbed. With high levels of indebtedness, imposing high interest rates, even for short periods of time, is like signing a death warrant for many of the firms—and for the economy.
In fact, while the Asian economies did have some weaknesses that needed to be addressed, they were no worse th
an those in many other countries, and surely nowhere near as bad as the IMF suggested. Indeed, the rapid recovery of Korea and Malaysia showed that, in large measure, the downturns were not unlike the dozens of recessions that have plagued market economies in the advanced industrial countries in the two hundred years of capitalism. The countries of East Asia not only had an impressive record of growth, as we have already noted, but they had had fewer downturns over the previous three decades than any of the advanced industrial countries. Two of the countries had had only one year of negative growth; two had had no recession in thirty years. In these and other dimensions, there was more to praise in East Asia than to condemn; and if East Asia was vulnerable, it was a newly acquired vulnerability—largely the result of the capital and financial market liberalization for which the IMF was itself partly culpable.
Hooverite Contractionary Policies: An Anomaly in the Modern World
For more than seventy years there has been a standard recipe for a country facing a severe economic downturn. The government must stimulate aggregate demand, either by monetary or fiscal policy—cut taxes, increase expenditures, or loosen monetary policy. When I was chairman of the Council of Economic Advisers, my main objective was to maintain the economy at full employment and maximize long-term growth. At the World Bank, I approached the problems of the countries in East Asia with the same perspective, evaluating policies to see which would be most effective in both the short and long term. The crisis economies of East Asia were clearly threatened with a major downturn and needed stimulation. The IMF pushed exactly the opposite course, with consequences precisely of the kind that one would have predicted.