Globalization and Its Discontents Revisited

by Joseph E. Stiglitz

  At the time of the onset of the crisis, East Asia was in rough macrobalance—with low inflationary pressures and government budgets in balance or surplus. This had two obvious implications. First, the collapse of the exchange rate and the stock markets, the breaking of the real estate bubbles, accompanied by falling investment and consumption, would send it into a recession. Second, the economic collapse would result in collapsing tax revenues, and leave a budget gap. Not since Herbert Hoover have responsible economists argued that one should focus on the actual deficit rather than the structural deficit, that is, the deficit that would have been there had the economy been operating at full employment. Yet this is precisely what the IMF advocated.

  Today, the IMF admits that the fiscal policy it recommended was excessively austere.11 The policies made the recession far worse than it needed to be. During the crisis, however, in the Financial Times the IMF’s first deputy managing director Stanley Fischer defended the IMF’s policies, writing, in effect, that all the IMF was asking of the countries was to have a balanced budget!12 Not for sixty years have respectable economists believed that an economy going into a recession should have a balanced budget.

  I felt intensely about this issue of balanced budgets. While I was at the Council of Economic Advisers, one of our major battles was over the balanced budget amendment to the Constitution. This amendment would have required the federal government to limit its expenditures to its revenues. We, and Treasury, were against it because we believed that it was bad economic policy. In the event of a recession, it would be all the more difficult to use fiscal policy to help the economy recover. As the economy goes into a recession, tax revenues decrease, and the amendment would have required the government to cut back expenditures (or increase taxes), which would have depressed the economy further.

  Passing the amendment would have been tantamount to the government walking away from one of its central responsibilities, maintaining the economy at full employment. Despite the fact that expansionary fiscal policy was one of the few ways out of recession, and despite the administration’s opposition to the balanced budget amendment, the U.S. Treasury and the IMF advocated the equivalent of a balanced budget amendment for Thailand, Korea, and other East Asian countries.

  Beggar-Thyself Policies

  Of all the mistakes the IMF committed as the East Asia crisis spread from one country to another in 1997 and 1998, one of the hardest to fathom was the Fund’s failure to recognize the important interactions among the policies pursued in the different countries. Contractionary policies in one country not only depressed that country’s economy but had adverse effects on its neighbors. By continuing to advocate contractionary policies the IMF exacerbated the contagion, the spread of the downturn from one country to the next. As each country weakened, it reduced its imports from its neighbors, thereby pulling its neighbors down.

  The beggar-thy-neighbor policies of the 1930s are generally thought to have played an important role in the spread of the Great Depression. Each country hit by a downturn tried to bolster its own economy by cutting back on imports and thus shifting consumer demand to its own products. A country would cut back on imports by imposing tariffs and by making competitive devaluations of its currency, which made its own goods cheaper and other countries’ more expensive. However, as each country cut back on imports, it succeeded in “exporting” the economic downturn to its neighbors. Hence the term beggar-thy-neighbor.

  The IMF devised a strategy that had an effect which was even worse than the beggar-thy-neighbor policies that had devastated countries around the world during the depression of the 1930s. Countries were told that when facing a downturn they must cut back on their trade deficit, and even build a trade surplus. This might be logical if the central objective of a country’s macroeconomic policy were to repay foreign creditors. By building up a war chest of foreign currency, a country will be better able to pay its bills—never mind the cost to those inside the country or elsewhere. Today, unlike the 1930s, enormous pressure is put on a country not to increase tariffs or other trade barriers in order to decrease imports, even if it faces a recession. The IMF also inveighed strongly against further devaluation. Indeed, the whole point of the bailouts was to prevent a further decrease in the exchange rate. This itself might seem peculiar, given the IMF’s otherwise seeming faith in markets: why not let market mechanisms determine exchange rates, just as they determine other prices? But intellectual consistency has never been the hallmark of the IMF, and its single-minded worries about inflation being set off by devaluation have always prevailed. With tariffs and devaluations ruled out, there were but two ways to build a trade surplus. One was to increase exports; but this is not easy, and cannot be done quickly, particularly when the economies of your major trading partners are weak and your own financial markets are in disarray, so exporters cannot obtain finance to expand. The other was to reduce imports—by cutting incomes, that is, inducing a major recession. Unfortunately for the countries, and the world, this was the only option left. And this is what happened in East Asia in the late 1990s: contractionary fiscal and monetary policies combined with misguided financial policies led to massive economic downturns, cutting incomes, which reduced imports and led to huge trade surpluses, giving the countries the resources to pay back foreign creditors.

  If one’s objective was to increase the size of reserves, the policy was a success. But at what expense to the people in the country, and their neighbors! Hence the name of these policies—“beggar-thyself.” The consequence for any country’s trading partners was exactly the same as if beggar-thy-neighbor policies had actually been pursued. Each country’s imports were cut back, which is the same as other countries’ exports being cut. From the neighbors’ perspectives, they couldn’t care less why exports were cut; what they saw was the consequence, a reduction of sales abroad. Thus the downturn was exported around the region. Only this time, there was not even the saving grace that as the downturn was exported, the domestic economy was strengthened. As the downturn spread around the world, slower growth in the region led to a collapse in commodity prices, like oil, and the collapse in those prices wrought havoc in oil-producing countries like Russia.

  Of all the failures of the IMF, this is perhaps the saddest, because it represented the greatest betrayal of its entire raison d’être. It did worry about contagion—contagion from one capital market to another transmitted through the fears of investors—though as we saw in the last section, the policies it had pushed had made the countries far more vulnerable to the volatility of investor sentiment. A collapse in the exchange rate in Thailand might make investors in Brazil worry about markets there. The buzzword was confidence. A lack of confidence in one country could spread to a lack of confidence in emerging markets. But more generally, the IMF’s performance as market psychologist left something to be desired. Creating deep recessions with massive bankruptcies and/or pointing out deep-seated problems in the best performing region of the emerging markets are policies hardly designed to restore confidence. But even had it done better in restoring confidence, questions should have been raised: in focusing on protecting investors, it had forgotten about those in the countries it was supposed to be helping; in focusing on financial variables, like exchange rates, it had almost forgotten about the real side of the economy. It had lost sight of its original mission.

  Strangling an Economy with High Interest Rates

  Today, the IMF agrees that the fiscal policies (those relating to the levels of government deficits) it pushed were excessively contractionary, but it does not own up to the mistakes of monetary policy. When the Fund entered East Asia, it forced countries to raise interest rates to what, in conventional terms, would be considered astronomical levels. I remember meetings where President Clinton was frustrated that the Federal Reserve Bank, headed by Alan Greenspan, an appointee from past administrations, was about to raise interest rates one-quarter or one-half percentage point. He worried that it would destroy “his” recover
y. He felt he had been elected on a platform of “It’s the economy, stupid,” and “Jobs, Jobs, Jobs” and he didn’t want the Fed to hurt his plans. He knew that the Fed was concerned with inflation, but thought those fears were excessive—a sentiment which I shared, and which the subsequent events bore out. The president worried about the adverse effect interest rate increases would have on unemployment, and the economic recovery just getting underway. And this in the country with one of the best business environments in the world. Yet in East Asia, IMF bureaucrats, who were even less politically accountable, forced interest rate increases not ten but fifty times greater—interest rate increases of more than 25 percentage points. If Clinton worried about the adverse effects of a half-point increase on an economy experiencing a nascent recovery, he would have been apoplectic about the effect of those huge increases in interest rates on an economy plunging into a recession. Korea first raised its interest rates to 25 percent, but was told that to be serious it must allow interest rates to go still higher. Indonesia raised its interest rates in a preemptive move before the crisis, but was told that that was not good enough. Nominal interest rates soared.

  The reasoning behind these policies was simple, if not simplistic. If a country raised interest rates, it would make it more attractive for capital to flow into that country. Capital flows into the country would help support the exchange rate and thus stabilize the currency. End of argument.

  At first glance, this appears logical. However, consider the case of South Korea as an example. Recall that in South Korea the crisis was started by foreign banks refusing to roll over their short-term loans. They refused because they worried about South Korean firms’ ability to repay. Bankruptcy—default—was at the center of the discussion. But in the IMF model—as in the models of most of the macroeconomics textbooks written two decades ago—bankruptcy plays no role. To discuss monetary policy and finance without bankruptcy is like Hamlet without the Prince of Denmark. At the heart of the analysis of the macroeconomy should have been an analysis of what an increase in interest rates would do to the chances of default and to the amount that creditors can recover in the event of default. Many of the firms in East Asia were highly indebted, and had huge debt equity ratios. Indeed, the excessive leverage had repeatedly been cited as one of South Korea’s weaknesses, even by the IMF. Highly leveraged companies are particularly sensitive to interest rate increases, especially to the extremely high levels urged by the IMF. At very high interest rate levels, a highly leveraged company goes bankrupt quickly. Even if it does not go bankrupt, its equity (net worth) is quickly depleted as it is forced to pay huge amounts to creditors.

  The Fund recognized that the underlying problems in East Asia were weak financial institutions and overleveraged firms; yet it pushed high interest rate policies that actually exacerbated those problems. The consequences were precisely as predicted: The high interest rates increased the number of firms in distress, and thereby increased the number of banks facing nonperforming loans.13 This weakened the banks further. The increased distress in the corporate and financial sectors exacerbated the downturn that the contractionary policies were inducing through the reduction in aggregate demand. The IMF had engineered a simultaneous contraction in aggregate demand and supply.

  In defending its policies, the IMF said they would help restore market confidence in the affected countries. But clearly countries in deep recession did not inspire confidence. Consider a Jakarta businessman who has put almost all of his wealth into East Asia. As the regional economy plummets—as contractionary policies take hold and amplify the downturn—he suddenly realizes that his portfolio is hardly sufficiently diversified, and shifts investment to the booming U.S. stock market. Local investors, just like international investors, were not interested in pouring money into an economy going into a tailspin. Higher interest rates did not attract more capital into the country. On the contrary, the higher rates made the recession worse and actually drove capital out of the country.

  The IMF came up with another defense, of no more validity. They argued that if interest rates were not greatly increased, the exchange rate would collapse, and this would be devastating to the economy, as those who had dollar-denominated debts would not be able to pay them. But the fact was that, for reasons that should have been apparent, raising interest rates did not stabilize the currency; the countries were thus forced to lose on both accounts. Moreover, the IMF never bothered to look at the details of what was going on inside the countries. In Thailand, for instance, it was the already bankrupt real estate firms and those that lent to them who had the most foreign-denominated debt. Further devaluations might have harmed the foreign creditors but would not have made these firms any more dead. In effect, the IMF made the small businesses and other innocent bystanders pay for those who had engaged in excessive dollar borrowing—and to no avail.

  When I pleaded with the IMF for a change in policies, and pointed out the disaster that would ensue if the current course were to be continued, there was a curt reply: If I were proven correct, the Fund would change its policies. I was appalled by this wait-and-see attitude. All economists know there are long lags in policy. The benefits of changing course will not be felt for six to eighteen months, while enormous damage could be done in the meantime.

  That damage was done in East Asia. Because many firms were highly leveraged, many were forced into bankruptcy. In Indonesia, an estimated 75 percent of all businesses were put into distress, while in Thailand close to 50 percent of bank loans became nonperforming. Unfortunately, it is far easier to destroy a firm than to create a new one. Lowering interest rates would not un-bankrupt a firm that had been forced into bankruptcy: its net worth would still have been wiped out. The IMF’s mistakes were costly, and slow to reverse.

  Naive geopolitical reasoning, vestiges of Kissinger-style realpolitik compounded the consequences of these mistakes. In 1997, Japan offered $100 billion to help create an Asian Monetary Fund, in order to finance the required stimulative actions. But Treasury did everything it could to squelch the idea. The IMF joined in. The reason for the IMF’s position was clear: While the IMF was a strong advocate of competition in markets, it did not want competition in its own domain, and the Asian Monetary Fund would provide that. The U.S. Treasury’s motivations were similar. As the only shareholder of the IMF with veto power, the United States had considerable say in IMF policies. It was widely known that Japan disagreed strongly with the IMF’s actions—I had repeated meetings with senior Japanese officials in which they expressed misgivings about IMF policies that were almost identical to my own.14 With Japan, and possibly China, as the likely major contributors to the Asian Monetary Fund, their voices would predominate, providing a real challenge to American “leadership”—and control.

  The importance of control—including control over the media—was brought home forcefully in the early days of the crisis. When World Bank Vice President for East Asia Jean Michel Severino pointed out in a widely discussed speech that several countries in the region were going into a deep recession, or even depression, there was a strong response from Treasury. It was made clear that it was simply unacceptable to use the R (for recession) or D (for depression) words, even though by then it was clear that Indonesia’s GDP was likely to fall between 10 to 15 percent, a magnitude that clearly warranted the use of those harsh terms.

  Eventually, Summers, Fischer, Treasury, and the IMF could not ignore the depression. Japan once again made a generous offer to help under the Miyazawa Initiative, named after Japan’s finance minister. This time the offer was scaled down to $30 billion, and was accepted. But even then the United States argued that the money should be spent not to stimulate the economy through fiscal expansion, but for corporate and financial restructuring—effectively, to help bail out American and other foreign banks and other creditors. The squashing of the Asian Monetary Fund is still resented in Asia and many officials have spoken to me angrily about the incident. Three years after the crisis, the countrie
s of East Asia finally got together to begin, quietly, the creation of a more modest version of the Asian Monetary Fund, under the innocuous name of the Chang Mai Initiative, named after the city in northern Thailand where it was launched.

  THE SECOND ROUND OF MISTAKES: BUMBLING RESTRUCTURING

  As the crisis worsened, the need for “restructuring” became the new mantra. Banks that had bad loans on their books should be shut down, companies that owed money should be closed or taken over by their creditors. The IMF focused on this rather than simply performing the role it was supposed to fill: providing liquidity to finance needed expenditures. Alas, even this focus on restructuring failed, and much of what the IMF did helped push the sinking economies down further.

  Financial Systems

  The East Asia crisis was, first and foremost, a crisis of the financial system, and this needed to be dealt with. The financial system can be compared to the brain of the economy. It allocates scarce capital among competing uses by trying to direct it to where it is most effective, in other words, where it yields the highest returns. The financial system also monitors the funds to ensure that they are used in the way promised. If the financial system breaks down, firms cannot get the working capital they need to continue existing levels of production, let alone finance expansion through new investment. A crisis can give rise to a vicious circle wherein banks cut back on their finance, leading firms to cut back on their production, which in turn leads to lower output and lower incomes. As output and incomes plummet, profits fall, and some firms are even forced into bankruptcy. When firms declare bankruptcy, banks’ balance sheets become worse, and the banks cut back lending even further, exacerbating the economic downturn.