Globalization and Its Discontents Revisited

by Joseph E. Stiglitz

  Malaysia and China

  By contrasting what happened in Malaysia and in China, two nations that chose not to have IMF programs, with the rest of East Asia, which did, the negative effects of the IMF policies will show clearly. Malaysia was severely criticized during the crisis by the international financial community. Though Prime Minister Mahathir’s rhetoric and human rights policies often leave much to be desired, many of his economic policies were a success.

  Malaysia was reluctant to join the IMF program, partly because officials there did not want to be dictated to by outsiders but also because they had little confidence in the IMF. Early on in the 1997 crisis, IMF chief Michael Camdessus announced that Malaysia’s banks were in a weak position. An IMF/World Bank team was quickly dispatched to look at the country’s banking system. While there was a high level of nonperforming loans (15 percent), Malaysia’s Central Bank had imposed strong regulations which had resulted in banks making adequate provisions for these losses. Moreover, Malaysia’ strong regulatory stance had prevented banks from exposure to foreign exchange volatility (the danger of borrowing in dollars and lending in ringgit), and had even limited the foreign indebtedness of the companies to which these banks lent (precautionary prescriptions which were, at the time, not part of the IMF standard package).

  The standard way to assess the strength of a banking system is to subject it, in simulation exercises, to stress tests and evaluate its response under different economic circumstances. The Malaysian banking system fared quite well. Few banking systems could survive a long recession, or a depression, and Malaysia’s was no exception; but Malaysia’s banking system was remarkably strong. During one of my many visits to Malaysia, I saw the discomfort of the IMF staffers writing the report: how to formulate it without contradicting the managing director’s assertions and yet remain consistent with the evidence.

  Within Malaysia itself, the issue of the appropriate response to the crisis was hotly debated. Finance Minister Anwar Ibrahim proposed “an IMF program without the IMF,” that is, raising interest rates and cutting back on expenditures. Mahathir remained skeptical. Eventually, he dumped his finance minister and economic policies were reversed.

  As the regional crisis grew into a global crisis, and international capital markets went into a seizure, Mahathir acted again. In September 1998, Malaysia pegged the ringgit at 3.80 to the dollar, cut interest rates, and decreed that all offshore ringgit be repatriated by the end of the month. The government also imposed tight limits on transfers of capital abroad by residents in Malaysia and froze the repatriation of foreign portfolio capital for twelve months. These measures were announced as short term, and were carefully designed to make it clear that the country was not hostile to long-term foreign investment. Those who had invested money in Malaysia and had profits were allowed to take them out. On September 7, 1998, in a now-famous column in Fortune magazine, the noted economist Paul Krugman urged Mahathir to impose capital controls. But he was in the minority. Malaysia’s Central Bank governor Ahmad Mohamed Don and his deputy, Fong Weng Phak, both resigned, reportedly because they disagreed with the imposition of the controls. Some economists—those from Wall Street joined by the IMF—predicted disaster when the controls were imposed, saying foreign investors would be scared off for years to come. They expected foreign investment to plummet, the stock market to fall, and a black market in the ringgit, with its accompanying distortions, to form. And, they warned, while the controls would lead to a drying up of capital inflows, they would be ineffective in stopping capital outflows. Capital flight would occur anyway. Pundits predicted that the economy would suffer, growth would be halted, the controls would never be lifted, and that Malaysia was postponing addressing the underlying problems. Even Treasury Secretary Robert Rubin, usually of such quiet demeanor, joined in the communal tongue-lashing.

  In fact, the outcome was far different. My team at the World Bank worked with Malaysia to convert the capital controls into an exit tax. Since rapid capital flows into or out of a country cause large disturbances, they generate what economists call “large externalities”—effects on other, ordinary people not involved in these capital flows. Such flows lead to massive disturbances to the overall economy. Government has the right, even the obligation, to take measures to address such disturbances. In general, economists believe that market-based interventions such as taxes are more effective and have fewer adverse side effects than direct controls, so we at the World Bank encouraged Malaysia to drop direct controls and impose an exit tax. Moreover, the tax could be gradually lowered, so that there would be no large disturbance when the interventions were finally removed.

  Things worked just as planned. Malaysia removed the tax just as it had promised, one year after the imposition of controls. In fact, Malaysia had once before imposed temporary capital controls, and had removed them as soon as things stabilized. This historical experience was ignored by those who attacked the country so roundly. In the one-year interim, Malaysia had restructured its banks and corporations, proving the critics, who had said that it was only with the discipline that comes from free capital markets that governments ever do anything serious, wrong once again. Indeed, it had made far more progress in that direction than Thailand, which followed the IMF prescriptions. In retrospect, it was clear that Malaysia’s capital controls allowed it to recover more quickly, with a shallower downturn,15 and with a far smaller legacy of national debt burdening future growth. The controls allowed it to have lower interest rates than it could otherwise have had; the lower interest rates meant that fewer firms were put into bankruptcy, and so the magnitude of publicly funded corporate and financial bailout was smaller. The lower interest rates meant too that recovery could occur with less reliance on fiscal policy, and consequently less government borrowing. Today, Malaysia stands in a far better position than those countries that took IMF advice. There was little evidence that the capital controls discouraged foreign investors. Foreign investment actually increased.16 Because investors are concerned about economic stability, and because Malaysia had done a far better job in maintaining that stability than many of its neighbors, it was able to attract investment.

  CHINA WAS THE other country that followed an independent course. It is no accident that the two large developing countries spared the ravages of the global economic crisis—India and China—both had capital controls. While developing world countries with liberalized capital markets actually saw their incomes decline, India grew at a rate in excess of 5 percent and China at close to 8 percent. This is all the more remarkable given the overall slowdown in world growth, and in trade in particular, during that period. China achieved this by following the prescriptions of economic orthodoxy. These were not the Hooverite IMF prescriptions, but the standard prescriptions that economists have been teaching for more than half a century: When faced with an economic downturn, respond with expansionary macroeconomic policy. China seized the opportunity to combine its short-run needs with long-run growth objectives. The rapid growth over the preceding decade, anticipated to continue into the next century, created enormous demands on infrastructure. There were large opportunities for public investments with high returns, including projects underway that were sped up, and projects that were already designed but had been put on the shelf for lack of funds. The standard medicines worked, and China averted a growth slowdown.

  While making economic policy decisions, China was aware of the link between macrostability and its microeconomy. It knew that it needed to continue restructuring its corporate and financial sector. However, it also recognized that an economic slowdown would make it all the more difficult to proceed with a reform agenda. An economic slowdown would throw more firms into distress and make more loans nonperforming, thereby weakening the banking system. An economic slowdown would also increase unemployment, and rising unemployment would make the social costs of restructuring the state enterprises much higher. And China recognized the links between economics and political and social stability. It
had in its recent history all too often experienced the consequences of instability, and wanted none of that. In all respects, China fully appreciated the systemic consequences of macroeconomic policies, consequences that the IMF policies habitually overlooked.

  This is not to say that China is out of the woods. The restructuring of its banking and state-owned enterprises still represents a challenge for it in the years ahead. But these are challenges that can be far better addressed in the context of a strong macroeconomy.

  Though the differences in individual circumstances make the reasons either for the occurrence of a crisis or for quick recovery hard to ascertain, I think it is no accident that the only major East Asian country, China, to avert the crisis took a course directly opposite that advocated by the IMF, and that the country with the shortest downturn, Malaysia, also explicitly rejected an IMF strategy.

  Korea, Thailand, and Indonesia

  Korea and Thailand provide further contrasts. After a short period of policy vacillation from July through October 1997, Thailand followed IMF prescriptions almost perfectly. Yet more than three years after the beginning of the crisis, it was still in recession, with a GDP approximately 2.3 percent below the pre-crisis level. Little corporate restructuring had taken place, and close to 40 percent of the loans were still nonperforming.

  In contrast, Korea did not close down banks according to the standard IMF prescription, and the Korean government, like Malaysia’s, took a more active role in restructuring corporations. Moreover, Korea kept its exchange rate low, rather than letting it rebound. This was ostensibly to enable it to reestablish its reserves, but by buying dollars for its reserves it depressed the value of the won. Korea kept the exchange rate low in order to sustain exports and limit imports. Moreover, Korea did not follow the IMF’s advice concerning physical restructuring. The IMF acted as if it knew more about the global chip industry than these firms who had made it their business, and argued that Korea should quickly get rid of the excess capacity. Korea, smartly, ignored this advice. As the demand for chips recovered, the economy recovered. Had the IMF’s advice been followed, the recovery would have been far more muted.

  In evaluating the recoveries, most analysts put Indonesia aside, simply because the economy has been dominated by political events and social turmoil. However, the political and social turmoil are themselves attributable in no small measure to IMF policies, as we have seen. No one will know whether there could have been a more graceful transition from Suharto, but few would argue that it could have been more tumultuous.

  Effects on the Future

  Despite the many hardships, the East Asia crisis has had salutary effects. East Asian countries will undoubtedly develop better financial regulatory systems, and better financial institutions overall. Though its firms had already demonstrated a remarkable ability to compete in the global marketplace, Korea is likely to emerge with a more competitive economy. Some of the worst aspects of corruption, the so-called crony capitalism, will have been checked.

  However, the manner in which the crisis was addressed—particularly the use of high interest rates—is likely to have a significantly adverse effect on the region’s intermediate, and possibly long-term, economic growth. There is a certain irony in the central reason for this. Weak, underregulated financial institutions are bad because they lead to bad resource allocations. While East Asia’s banks were far from perfect, over the preceding three decades their achievements in allocating the enormous flows of capital were, in fact, quite impressive—this was what sustained their rapid growth. Although the intention of those pushing for “reforms” in East Asia was to improve the ability of the financial system to allocate resources, in fact, the IMF’s policies are likely to have impaired the overall efficiency of the market.

  Around the world, very little new investment is financed by raising new equity (selling shares of stock in a company). Indeed, the only countries with widely diversified share ownership are the United States, the United Kingdom, and Japan, all of which have strong legal systems and strong shareholder protections. It takes time to develop these legal institutions, and few countries have succeeded in doing so. In the meantime, firms around the world must rely on debt. But debt is inherently risky. IMF strategies, such as capital market liberalization and raising interest rates to exorbitant levels when a crisis occurs, make borrowing even riskier. To respond rationally, firms will engage in lower levels of borrowing and force themselves to rely more heavily on retained earnings. Thus growth in the future will be constrained, and capital will not flow as freely as it otherwise would to the most productive uses. In this way, IMF policies lead to less efficient resource allocation, particularly capital allocation, which is the scarcest resource in developing countries. The IMF does not take this impairment into account because its models do not reflect the realities of how capital markets actually work, including the impact of the imperfections of information on capital markets.

  EXPLAINING THE MISTAKES

  While the IMF now agrees it made serious mistakes in its fiscal policy advice, in how it pushed bank restructuring in Indonesia, in perhaps pushing capital market liberalization prematurely, and in underestimating the importance of the interregional impacts, by which the downfall of one country contributed to that of its neighbors, it has not admitted to the mistakes in its monetary policy, nor has it even sought to explain why its models failed so miserably in predicting the course of events. It has not sought to develop an alternative intellectual frame—implying that in the next crisis, it may well make the same mistakes. (In January 2002, the IMF chalked up one more failure to its credit—Argentina. Part of the reason is its insistence once again on contractionary fiscal policy.)

  Part of the explanation of the magnitude of the failures has to do with hubris: no one likes to admit a mistake, especially a mistake of this magnitude or with these consequences. Neither Fischer nor Summers, neither Rubin nor Camdessus, neither the IMF nor the U.S. Treasury wanted to think that their policies were misguided. They stuck to their positions, in spite of what I viewed as overwhelming evidence of their failure. (When the IMF finally decided to support lower interest rates and reversed its support for fiscal contraction in East Asia, it said it was because the time was right. I would suggest that it reversed courses partly due to public pressure.)

  But in Asia other theories abound, including a conspiracy theory that I do not share which views the policies either as a deliberate attempt to weaken East Asia—the region of the world that had shown the greatest growth over the previous forty years—or at least to enhance the incomes of those on Wall Street and the other money centers. One can understand how this line of thinking developed: The IMF first told countries in Asia to open up their markets to hot short-term capital. The countries did it and money flooded in, but just as suddenly flowed out. The IMF then said interest rates should be raised and there should be a fiscal contraction, and a deep recession was induced. As asset prices plummeted, the IMF urged affected countries to sell their assets even at bargain basement prices. It said the companies needed solid foreign management (conveniently ignoring that these companies had a most enviable record of growth over the preceding decades, hard to reconcile with bad management) and that this would only happen if the companies were sold to foreigners—not just managed by them. The sales were handled by the same foreign financial institutions that had pulled out their capital, precipitating the crisis. These banks then got large commissions from their work selling the troubled companies or splitting them up, just as they had got large commissions when they had originally guided the money into the countries in the first place. As the events unfolded, cynicism grew even greater: some of these American and other financial companies didn’t do much restructuring; they just held the assets until the economy recovered, making profits from buying at the fire sale prices and selling at more normal prices.

  I believe that there is a simpler set of explanations—the IMF was not participating in a conspiracy, but it was refle
cting the interests and ideology of the Western financial community. Modes of operation which were secretive insulated the institution and its policies from the kind of intensive scrutiny that might have forced it to use models and adopt policies that were appropriate to the situation in East Asia. The failures in East Asia bear much in common with those in development and in transition, and in chapters 12 and 13 we will take a closer look at the common causes.

  AN ALTERNATIVE STRATEGY

  In response to the complaints I continue to raise about the IMF-Treasury strategy, my critics have rightly asked what I would have done. This chapter has already hinted at the basic strategy: Maintain the economy at as close to full employment as possible. Attaining that objective, in turn, entails an expansionary (or at least not contractionary) monetary and fiscal policy, the exact mix of which would depend on the country in question. I agreed with the IMF on the importance of financial restructuring—addressing the problems of weak banks—but I would have approached it totally differently, with a primary objective of maintaining the flow of finance, and a standstill on existing debt repayment: a debt restructuring, such as that which eventually worked for Korea. Maintaining the flow of finance, in turn, would require greater efforts at restructuring existing institutions. And a key part of corporate restructuring would entail the implementation of a special bankruptcy provision aimed at the quick resolution of distress resulting from the macroeconomic disturbances that were well beyond the normal. The U.S. bankruptcy code has provisions which allow for relatively quick reorganization of a firm (rather than liquidation), called Chapter 11. Bankruptcy induced by macroeconomic disturbances, as in East Asia, call for an even faster resolution—in what I refer to as a super-Chapter 11.