Asia: The Collapse and the Cure

1.

Economic collapses are an intrinsic part of capitalism. The names of the really big crashes ring down through history: Tulip Mania in Holland in the 1600s, the South Sea Bubble in Britain in the 1700s, the Great Crash of 1929 in America. More recently, in the 1990s, the Japanese bubble ended with stock prices down two thirds and property prices down 70 percent. Seven years later the stock market has yet to recover and property prices are still falling.

Past infections do not provide future immunity. America in the 1970s and 1980s saw the effective bankruptcy of its largest city, a government bailout of Chrysler, one of its largest corporations, the collapse of its Savings and Loan banking industry, a stock market crash in 1987, and a sharp fall in property prices. The latter rolled around much of the rest of the industrial world. Canary Wharf in London, which cost twelve billion dollars to build, was at one time worth half a billion dollars.

Today it is the turn of large parts of Asia. In Korea on December 27, stock market values were down 42 percent for the year and the won had lost half its value against the dollar. Combining these declines, stock prices had, in dollar terms, fallen by two thirds for the year. And Samsung Electronics Company, the world’s largest producer of computer memory chips, according to a report in The New York Times, now has a market capitalization—the value of all its outstanding shares—of about what it would cost to build one of its factories. At the same time the company is carrying $7.9 billion in debt.¹

2.

The sequence of events in a crash are well known. Some asset rises in value to levels far above those that can be sustained. At the peak of Tulip Mania one black tulip bulb bought one of the row houses along the canals in Amsterdam. That price was crazy, and everyone knew it, but prices were just as crazy when six tulip bulbs bought one house and those who got out of the tulip market when it was 6 to 1 missed a chance to multiply their wealth by a factor of six. Short-run opportunities to make a lot of money overwhelm well-known long-run economic realities. Every investor (no one thinks of himself as a speculator) imagines that he will be able to see the end coming and get out in time—but few do.

As asset prices fall, what had been good loans become bad loans. Adequate collateral becomes inadequate collateral and loans with inadequate collateral get called for payment. Fearful of defaults or short of liquidity themselves, banks don’t renew short-term loans that normally would be automatically rolled over. Working capital dries up. Suppliers who are fearful of not being paid demand cash before delivery instead of being willing to wait the normal ninety days for payment. Within hours of the news of the recent crisis, ships loaded with raw materials for Korea were halted off the coast, waiting for payments to clear before they unloaded. Even financially sound firms find that they cannot pay their bills since they are suddenly, unexpectedly, asked to repay loans and pre-pay suppliers. Business firms that cannot finance themselves go broke. Their customers don’t get the supplies they need.

Worried about preserving their wealth, insiders and outsiders convert their holdings to currencies that are not expected to depreciate. Vast amounts of money leave the country; the central bank eventually runs out of foreign exchange reserves; the currency plunges; the real cost of paying international loans rises and the central bank has to beg for loans from the IMF. And when central banks lack international reserve currencies, as with Korea’s recently, even companies with sufficient funds in local currency to repay their international loans cannot get the necessary foreign funds to repay their loans. A business crisis becomes a crisis for the country. Credit markets freeze up. The contagion spreads to other countries. Brazil, for example, has been very shaky in the aftermath of the Asian collapse.

The problem before the collapse is not in knowing that prices will eventually fall but in predicting the timing and speed of the downturn. Economic models are very good at describing fundamental forces and pressures, but they have proved of little use when it comes to timing.

In this sense economics is much like geology. Geologists have a very good general understanding of the plate tectonics that underlie the San Andreas fault in California. They know with near certainty that there will be a big earthquake in California. But they don’t know whether it will be one second or a thousand years from now. All a geologist can do is chart the faults and understand the probabilities. But Californians build houses right on top of the state’s biggest faults, sure it won’t happen in their lifetimes.

The big economic fault lines on the Pacific Rim have long been well known, most obviously, perhaps, in the performance of land values. In the long run, commercial land values have to reflect the underlying earnings capacity—the productivity—of the economic activities carried out on the real estate in question. Bangkok, a city whose per capita productivity is about one twelfth that of San Francisco, should not have land values that are much higher than those in San Francisco. But it did—as did other Southeast Asian cities. Grossly inflated property values had to come down.

It is a basic axiom of economics, taught in every introductory class on international trade, that no country can run a large trade deficit forever where its foreign indebtedness grows faster than its GDP. Foreign currencies have to be borrowed to finance such trade deficits. At some point the size of the already existing outstanding loans will cause lenders to conclude that extending more loans is too risky; repayment seems too unlikely. The credit markets shut down. The Asian countries whose economies have recently been collapsing were all running large trade deficits—$8 billion in Indonesia, $4 billion in Malaysia, $10 billion in Thailand, $4 billion in the Philippines, and $19 billion in Korea.

Ten years ago these countries all had substantial trade surpluses. Their swing from surplus to deficit is di-rectly traceable to mainland China’s decision to concentrate on increasing exports as the engine of its economic growth—what economists call “export-led growth.” Since China could offer better educated but cheaper workers than Southeast Asia, and since it has a much bigger internal market for its own products, it quickly gained a $40 billion trade surplus, taking export trade away from other Asian countries. To find substitutes for the kinds of goods whose production China was taking over, these countries needed to go upscale in technology very rapidly. But some of them are not well educated enough to do so.

And while Korean workers are on the whole better educated than those in China, Korean companies had moved their low-wage manufacturing export operations to China, and could not replace these exports with high-wage manufacturing exports, because of Japanese competition and Japan’s rapidly rising trade surplus. As has so often happened in its history, Korea was once again squeezed between its two powerful neighbors.

Eventually stock market prices have to reflect profits. In the collapsing Asian countries, competition and the desire to increase market share kept profits low while Asian stock markets had risen to levels that could not be justified by earnings. Before its crash in 1990, the Japanese market had price/earnings multiples of more than 100.

Moreover, projects were being built that everyone knew would lose money. The two tallest buildings in the world were built in Kuala Lumpur although it is now widely known that such buildings do not make economic sense. The Sears Tower in Chicago has just been sold at half its replacement cost and the World Trade Center in New York could not be sold for anything like its replacement cost. Too much space goes into elevators and other support activities when buildings rise to these heights, and no transportation system can economically get so many people to one location at nine o’clock in the morning. But when countries have had a string of boom years megalomania sets in and their governments and large investors come to feel that ordinary economic rules that apply to others do not apply to them. In 1995, when I wrote The Future of Capitalism, I was only one of several commentators who believed that such trends could not continue:

The question is not whether an earthquake will occur. It will. The only question is when, and whether it occurs as one big shock or as a series of smaller shocks that do less damage. But when conditions have existed for a long period of time and nothing happens, humans, being human, begin to believe that it is possible to defy economic gravity forever…. But let no one doubt that this earthquake will happen…. The forces on each side of the fault are enormous.

But knowledge that an economic earthquake would eventually occur on the Pacific Rim would have been of little value to most investors. In financial markets most successful investors make money because of their timing—not through an understanding of basic economic forces. From their own short-term point of view, those in the financial markets were right to ignore such warnings.

What is clear by now is that crashes are not set off by outside speculators who see the internal weaknesses and attack. The first investors to leave the local market are always the local investors who have the best information. Indonesian industrialists got their money out of Indonesia first since they were the ones who had borrowed money in dollars; they would go broke if they didn’t switch from their local currency before it fell. The real value of a firm’s debts more than doubles if loans must be repaid when the exchange rate is 5500 to 1 rather than 2300 to 1. The threat of going broke concentrates the debtor’s attention. Property developers in Manila have the best information about the rising office vacancy rate in the many new office towers they have helped to build. They know new buildings are not being successfully rented. The Korean industrialist with a cousin working at the central bank knows that the statistics published by the Korean Central Bank about the size of its reserves are false. The Thai banker is the first to know about the phony bookkeeping in the companies to which his bank has been lending money.

Outsiders are the last to know. By the time international speculators join the flight, the panic is well underway. We know that insiders were the first to convert to dollars in both the 1982 and 1994-1995 Mexican crises. When the crisis in Asia has calmed down, it will be clear that insiders were once again the first to run. The impressive abilities of international fund managers to move large sums of money across borders vastly accelerate the forces pushing prices down; but contrary to some facile generalizations about “globalization,” they are never the triggering mechanism.

The financial press talks as if the recent events would not have happened if Asia’s financial markets had been more open—“transparent”—and Asians talk as if these events would not have occurred if their markets had been more closed to foreign investment and influence. Both are wrong. Mexico managed to crash in 1982 when its banking system was entirely owned and controlled by the government. It also managed to collapse in the winter of 1994-1995 when it had completely privatized its banking system and had a wide-open financial market. Open financial markets in which governments do not own financial firms or control financial transactions and where foreigners and citizens compete on an equal basis are generally a good thing; but they are not an insurance policy against crashes. Neither is retreating to more government controls.

Nor is fiscal soundness an antidote. The governments of Asia were running budget surpluses—Korea had a large one. Mexico had a crash in 1982 when its government was running large budget deficits and was a big borrower. But it also had a financial collapse in 1994-1995 when its government was running budget surpluses.

Sooner or later, most economies experience a crash. Generalized claims that the Asian countries were stupidly or badly run will not adequately explain the crash or predict the future. The relevant question is which governments are going to be good at cleaning up the mess. The big losers will be those without effective governments to do it. In each case the actions of government will count heavily.

3.

The Great Crash of 1929 became the Great Depression of the 1930s because President Hoover was unable to deal with the situation. Left to fester, problems grew worse from 1929 to 1932 and by 1933, when Roosevelt became president, they were virtually unsolvable. Public policies never did in fact succeed in ending the Great Depression, which was finally superseded by the economic mobilization of World War II.

Conversely, the messes created by the effective bankruptcy of New York City, the near collapse of the Chrysler Corporation, the implosion of the Savings and Loan system, the 1987 stock market crash, and the sharp fall in US property prices had little impact on America’s real GDP growth rates in the 1970s and 1980s. Each of these failures was quickly and effectively dealt with, usually with the help of federal or state action. Similarly Taiwan experienced a crash when the stock market fell from 12,000 to 3,000 at the beginning of the 1990s, with no effects on its economic growth rate.

From the perspective of demonstrated abilities to deal with the aftermath of a collapse, Japan is the sickest country on the Pacific Rim. Seven years after its crash in 1990 it has made no progress in cleaning up its economic mess. The result has been a long period of stagnation, with negative growth expected in 1997 and 1998. Financial firms that would long ago have gone out of business if sensible government policies had been adopted are now collapsing under market pressures. The problems of banks that made bad loans continue to fester, and many are failing or about to fail. (The main Japanese bankers’ association said on December 26 that its 146 member banks reported a pre-tax loss of near 54 billion yen between April and September, the first loss since it started compiling data in 1958.² ) Many of the weak retailing and industrial firms to which the banks uncautiously made loans are failing along with them.

Monetary policies have been ineffective and timid measures to stimulate the economy generally have not had major effects. Personal taxes were raised when they should have been lowered, and only in late December did the government announce an income tax cut. Spending programs have concentrated on supporting inflated land values rather than stimulating output. Government projects for improving infrastructure, including roads, are not carried out because of the government’s unwillingness to use its powers of eminent domain to quickly acquire the necessary land on which to build.

As has been proposed by both Japanese and outside observers, Japan might have brought about a housing boom to restart its economy if it had been willing to change some of its obsolete regulations and tax laws. If rice land were subject to inheritance taxes, there would be no rice fields in the midst of urban Tokyo. When modern construction techniques are used, high-rise residential towers are actually safer during earthquakes than conventional low-rise buildings. But these methods are prohibited under Japan’s obsolete construction codes. And the current requirement that people building high-rise residential towers must negotiate with and compensate those that lie within their shadows essentially stops Japan from solving its urban housing problems as other countries have. All of these changes could have been made; none of them were. Talk about “restructuring” abounds; but the few major reforms that are planned are scheduled too far into the future. Financial markets, which suffer from a variety of restrictions on foreign and other investment, are to be liberalized, but only in 2001.

Japan’s government has demonstrated its incompetence, and its problems are getting worse. It has the strength of a $100 billion trade surplus and more than $200 billion in international reserves, so its currency is not going to be directly challenged. But the stability of its internal banking system is more than ever in question. Not only are thirteen of its nineteen largest banks expected to report losses for 1997, but many of these banks are probably hiding additional losses, as Yaminichi Securities did in 1997. Japanese banks already pay a large premium in higher interest rates when they roll over their international loans, and Japanese depositors are nervously moving their money into foreign banks.

The richest country in Asia, which should be helping to organize efforts to rescue its neighbors, thus needs to rescue itself. The countries whose economies have recently collapsed now have an aggregate trade deficit of $45 billion which they will have to eliminate quickly. If they bring their external trading accounts into balance, this will mean that other countries will have rising trade deficits or falling trade surpluses. Japan, a country with a $100 billion trade surplus, should be allowing some of that surplus to be transferred to its Asian neighbors—i.e., it should be purchasing more from those countries. This is far more important than its willingness to participate in IMF bailouts. But at the December Asian summit it told its neighbors not to count on Japan as a market for their products.

4.

While the collapse of the Pacific Rim economies should not have been surprising, it revealed some surprising facts. Private companies, such as those in Indonesia or Korea, had much bigger foreign currency debts than anyone had estimated. We now learn that the Koreans have borrowed some $160 billion in foreign currency, about half of this in short-term loans. This was not supposed to have been possible. Following the crashes in Latin America in the 1980s the international financial community supposedly set up a system by which banks in the industrial world would report on their total lending (private and public) country by country to the Bank for International Settlements in Switzerland so that it could sum up and report the totals. No country can get this information by itself since much of the lending is from offshore financial institutions. Without this information even national central banks don’t know how much foreign exchange reserves they will need to meet future demands. Whatever went wrong, the reporting system put in place did not work. Ignorance about total private borrowing seems to have been even deeper than during the 1980s.

While everyone knew that accounting systems were a little squishy on the Pacific Rim, everyone has been surprised by just how fraudulent they really were. Who would have believed that a major Japanese financial house would, with the knowledge of the Japanese Ministry of Finance, have been allowed to keep $2.6 billion in losses off its books? Who would have believed that the Korean Central Bank would report as national currency reserves funds that it had already lent to Korean companies to repay dollar-denominated loans?

As the US government had to do in the case of the S&L disaster, some outside authority is going to have to audit corporate and government books to certify them as reliable before normal private international lending, as distinguished from emergency loans by the IMF or national governments, can resume. This is also true for countries that probably have reliable accounting, such as Taiwan and Hong Kong. No one is going to believe anyone’s claim to honest bookkeeping on the Pacific Rim without some international “good housekeeping” seal of approval.

While everyone knew that the big Korean conglomerates, or chaebols, had large debts, no one believed that they were running as close to the edge of their borrowing capacity as has turned out to be the case. Within days of the commencement of the Korean crisis, companies such as Samsung and Hyundai (both with around $90 billion in annual sales) were announcing that they would be unable to finish construction of mostly completed factories because they were short of funds. Companies of this size would normally have enormous unused lines of credit with banks all around the world. In this case they must have completely used up their international lines of credit and have been counting on the Korean government as their lender of last resort.

5.

As for the consequences of the Asian collapse, if we consider only the initial decline in exports to Asia, the effect will be small. Apart from Japan, Asian countries buy so little from Europe and America that even if their imports were to be cut in half the effects on the economies of America and Europe would be very small. Most American companies in these countries have been set up as off-shore manufacturing sites whose major markets are back in the United States. Many of them export components to their Asian assembly plants that are re-exported back to America for final sale. These exports to Asia of these US companies will not decline, and in the end they will end up making money out of the Asian crisis because their costs of production will be much lower.

Since Asia will try to export its way out of its current problems, the big negative effects will be on those non-Asian industries that compete with Asian exporters. The Asians will try to export a lot more by dramatically cutting their prices. The countries of Southeast Asia export low-wage products such as athletic shoes and cheap toys for which few producers are left in the industrial world; as a result they will mainly force down prices for competing producers in other developing countries such as Mexico or Brazil. But the Koreans produce a range of goods, including steel, ships, and electronic equipment, that are competitive with those produced in the developed world. If a US company competes with Korean companies, it had better be prepared to sell its products for a lot less or lose a considerable market share.

If Korea’s currency is down more than 50 percent, as it now is, its companies will be able to sell products profitably for 50 percent less; but they will also reduce prices even further to insure that their factories run at capacity and that they earn every possible dollar of foreign exchange. Any US company making steel, ships, D-ram semiconductor chips, TV monitors, or any of the other products exported in volume by the Koreans ought to prepare for big losses in profits or a big loss in market share in 1998. The last major American maker of D-ram chips, Micron, is already reporting that it has difficulty competing with Korea.

But Korea’s competitors are to a great extent in Japan. The sickest economy in the developed world, the economy with a government that has demonstrated that it cannot deal with shocks, is now going to be under even greater pressure. Japan’s companies make little money now and, as Korean prices fall, they will make even less. Japan exports far more to the rest of Asia than either the United States or Europe, and its Asian exports will fall sharply. Japan is the biggest lender in Asia. The already bad situation of its banks is going to get worse.

Like the other Asian countries in difficulty, Japan will try to export its way out of its problems. In doing so each country will concentrate on the United States since it is the easiest developed market to penetrate. To accept the level of imports that would be necessary to rescue Asia, America would have to be willing to accept the displacement of a considerable number of workers from their current jobs. Even without factoring Japan’s problems into its calculations, the IMF, in its most recent forecast, expects the US trade deficit to go up by $50 billion. If this happens, about one million US workers would be affected. When we take account of the rising volume of Japanese exports, the effects are going to be much larger. Such a surge in Asian exports will produce strong political pressures in the US to restrict its imports.

If each Asian nation facing an economic downturn tries to export its way out of its problems, each one is going to find its way blocked by the lower costs of its neighbors; a sequence of competitive devaluations in currency could well take place. Each country could lower the value of its currency in order to gain a price advantage over its neighbors, only to find that its currency depreciations are undone by the even larger depreciations of its neighbor’s currency. To have the desired effects they must lower their currency values even further. Competitive devaluations were among the factors that converted the Great Crash of 1929 into the Great Depression of the 1930s.

Fears have been expressed that Japan would destabilize the United States by selling its large holdings of US Treasury bills to generate the liquidity necessary to revive its banking system. This it simply cannot do. If Japan wants to run a $100 billion trade surplus it has to lend $100 billion worth of yen to the rest of the world. In return it gets dollar-denominated IOUs. Without that lending, the rest of the world would not have the yen necessary to pay for its Japanese imports and would have to stop buying. That is one of the reasons why Japan’s banking system lent so much money in Southeast Asia even though its banks were already broke from its 1990 stock market and real estate crashes. If the lending stops, Japan’s trade surplus just as quickly disappears. To put the situation simply, selling American T-bills would disrupt Japan’s economy far more than it would disrupt America’s economy.

Many ask whether the other big Asian player, mainland China, will also collapse. Like Southeast Asia, China has had a property market boom that is ripe for a crash. Rents in Shanghai are just as much out of line with plausible long-term demand for real estate as they were in Southeast Asia. In fact one third of Shanghai’s office rental space is vacant. A property bust is almost a certainty. What we don’t know is how much of the money that fueled this property boom came from foreign banks in places like Japan, where the banking system is already on the edge of collapse.

What financial markets hate most is to be surprised. But no one can be surprised to learn that China’s banks are broke; they have long been known to be broke. Since they are government banks, they are forced to make huge loans to the large, money-losing state industries that are being propped up by the central government in order to stop unemployment from rising. No one expects these loans ever to be repaid since everyone knew they were bad loans the day they were made. And since all banks in China are government banks, the bad debt problem is a government problem. How much money is it willing to pump into the system to maintain China’s liquidity—the availability of funds to meet claims of depositors and creditors? In the end the government is probably willing to pump in any amount of liquidity and simply live with the resulting inflation. A property bust will make China’s banking problems quantitatively worse in China, but it won’t change the nature of its basic problems.

In contrast with the trade deficits of Southeast Asia or Korea, China’s economy has a big trade surplus. It does not need to borrow money to finance its imports. As far as we know, neither the Chinese government nor Chinese companies have many loans denominated in foreign currencies. China also has $100 billion in foreign exchange reserves. Since China does not have a convertible currency, it is under no obligation to convert Chinese currency into foreign currencies if investors decide that they wish to liquidate their holdings; but this does not mean that it cannot have a foreign currency crisis. If Chinese exporters stop bringing their funds back to China, and Chinese importers, fearing a future devaluation, start paying for their imports early, large outflows of funds can rapidly emerge despite currency controls.

While a collapse of China’s economy seems unlikely, an economic slowdown is almost a certainty.

6.

One of the benefits of having had a long history of financial crashes is that there is a broad consensus about what has to be done to quickly restore normalcy and bring economic systems back into operation. The question is whether the governments of Southeast Asia and Korea are willing to do what is necessary.

They don’t have to invent solutions. Their financial systems need some combination of the techniques used in the rescue of New York City from bankruptcy and the bailout of the US Savings and Loan industry. The process starts with reliable third-party accounting that divides the existing assets of banks and other financial institutions into good assets and bad assets. A good asset, for example, is a loan for a building that is fully rented and able to make the necessary mortgage payments. A bad asset is a loan on a building that is mostly vacant and not able to meet its mortgage obligations. For those banks with solid balance sheets, government lending can tide them over during the period when credit markets are frozen and they cannot roll over their existing loans. For those whose balance sheets show a preponderance of bad loans, the good assets can be auctioned off and the bad assets taken over by some equivalent of the S&L Resolution Trust.

In the end this takeover of bad debts has to be made acceptable to the taxpayers who will ultimately pay the bills. What will be required may differ from country to country, but in the United States the S&L bailout required three things. First, all shareholders in the banks had to lose all of their equity before any public funds were used. Second, in any seriously failing financial institution all of the top management team were subject to being fired, without expensive pensions or golden parachutes. Third, where criminal violations occurred, such as insider lending, top executives were subject to criminal punishment, including prison. Since most bad assets become good assets as their price goes down, the Asian equivalent of the Resolution Trust should quickly auction off bad assets for whatever price they would bring. Based on the experience of the American Resolution Trust, we know that no government agency has the ability to manage these assets so their values would be restored. In effect, equity would replace debt.

When it comes to failing industrial firms, the problems are different and the solutions have to be different. When banks fail, not much happens to the real economy other than the loss of a relatively small number of jobs. Most local branches even remain open. The borrower who can pay interest still has the money he has borrowed and in Korea, for example, the depositors are all protected. When big industrial firms are allowed to go broke, the job losses are much larger but the serious consequences go far beyond such losses. In contrast to what happens in the financial sector, neither those up or down the chain of distribution are protected. The suppliers may be well-run companies that go broke because they are not paid for goods already shipped. The firm’s industrial customers may go broke because they cannot quickly get the components they need to manufacture their own products.

In fact, in any economy there are industrial firms too large to be allowed to fail. If they were to fail, they would bring the national economy down with them. Four conglomerates account for half of the Korean GDP. But where the government is willing to rescue a badly run large company, the top management should be replaced; the shareholders should be both the first to lose their equity and the last to regain their equity during the recovery process.

In a situation of national collapse, nonfinancial firms too small to affect the national economy will simply be allowed to fail. This is entirely unfair; but there is no way government can replace the management in thousands of small firms; and in many cases the owners cannot be separated from the managers since the managers are the owners.

In the case of large conglomerates such as the Korean chaebols, separable parts of the companies should be broken off and then auctioned off to the highest bidder. Often this will mean foreign bidders because they are the only ones who have the dollars to invest that will be needed to pay off the dollar obligations owed by the firms that are being sold—and the expertise to run the parts of the firm that are being sold. There is today no shortage of American and European companies who are interested in buying parts of such firms.

If the government does end up having to make industrial loans as a last resort, it should always retain some equity ownership. If government takes a large risk of loss, the taxpayer should have the prospect of potential gain. In the Chrysler rescue, the American government made money on its warrants. A governmentally appointed oversight committee had to approve the company’s major investment and operational decisions until the government loans were repaid. In a government bailout, salaries and other forms of management pay should be kept low. Chrysler, for example, was not allowed to have a corporate plane; the new CEO, Lee Iacocca, accepted a minimal salary. His compensation came in the form of stock options that gave him high potential gains if he succeeded, as he did.

7.

To restart rapid economic growth on the Pacific Rim, however, is going to require something more than an ability to clean up the messes that have resulted from economic collapse. The countries that want to resume rapid growth will eventually have to understand that the era of export-led growth is over, and that they must make the structural changes necessary to shift to a strategy based on internal growth.

For countries relying on export-led growth, the main concern was to increase exports. If exports could grow at 15 to 20 percent per year, the country could then import enough to allow its domestic economy to grow at 7 to 8 percent per year. Export-led growth only works, however, when a few small countries play the game. The principal players in the 1970s and 1980s—South Korea, Taiwan, Hong Kong, and Singapore—together had 65 million people. When most of the world, and big countries such as China or Indonesia, want to play the game, the game ends. How can everyone increase their exports at 20 percent per year when the world economy only grows between 2 and 2.5 percent per year? They can’t.

We know that economies based on internal growth can work. That is how the American economy grew. But they require different industrial structures and different national economic policies from those prevailing in Asia. Public policies should concentrate on stimulating investments in industry and in infrastructure, and these should be the principal source of aggregate demand. With foreign exchange scarcer, the available international funds must be used largely to buy the essential investment goods—e.g., machine tools and other complex equipment—that the country is technologically unable to produce for itself. A competitive environment is sustained by letting foreigners compete under the same set of rules that apply to the country’s citizens. To emphasize internal growth is not to return to the model of quasi socialism and import substitution that was tried and that failed in most of the developed world. With such an internal growth policy, industry is neither government-owned nor government-financed. Foreigners are not kept out. On the contrary, they are encouraged to enter the market and drive locally owned businesses out of business—if they can.

In the end, the Asian countries that rapidly recover will be those with effective national governments capable of cleaning up the financial messes left behind by the collapse of their overvalued assets and those able to shift to internally based growth strategies. Those who cannot, like Japan for the last seven years, will find themselves caught in a long period of stagnation.

8.

The IMF will at best play a subsidiary role in determining who succeeds and who fails. Its principal function is not to provide international liquidity for those who need it, although doing so is important, but to take the blame for the stringent policies that will have to be imposed and thus provide some political shelter for the governments that impose them. Michel Camdessus and the other officials who manage the IMF do not have to run for office, and the IMF can take the blame for necessary but unpopular policies.

With some justification the IMF is accused of being a doctor with one medicine, austerity, that it administers whatever the disease. High interest rates and government budget surpluses are imposed to force savings rates up, slow growth down, and reduce imports so as to eliminate trade deficits. These policies may be appropriate in Latin America, where savings rates are low, but they are not appropriate in countries where savings rates are already very high—Korea has a 40 percent national savings rate. Austerity is also not appropriate when it has to be administered to many countries at the same time, since it ends up cutting worldwide aggregate demand and making economic problems worse by slowing world growth.

Historically the IMF has been very good at restoring international credibility and macroeconomic stability but very bad at restoring domestic prosperity. In Mexico it helped rescue international creditors, but the median income of Mexican families is still far below what it was in the summer of 1994. In this crisis the IMF should be willing to go beyond macroeconomic management. International financial stability cannot be its only goal.

The IMF, as has been suggested, should probably be the agency for setting up the procedures to certify that the accounting of governments and large companies is reliable. The IMF is right to call for more “transparency” in financial transactions, but that recommendation should apply to its own actions as well. The precise deal it has made with Korea, for example, has never been revealed in detail. The papers are full of rumors about the IMF’s demands, which may or may not be correct; but how can anyone sensibly invest in the Korean economy if he does not know what the IMF will require it to do?

While some loans will be made by the IMF, and Asian governments will bring pressure to obtain more, Asia is unlikely to be able to go back to its old system of debt finance. It is going to have to shift to a much more equity-based system. The IMF can speed up that process. Economies based on internal growth, which are subject to business cycles and downturns, cannot export their way out of recessions. They will need the resilience of equity finance; and to persuade investors to invest they will need much better regulated financial markets, with controls such as those imposed by the American SEC.

Americans are wrong to think that all conglomerates are inherently inefficient. (The most valuable company in the US, General Electric, is in fact a conglomerate despite protests to the contrary by its CEO, Jack Welch.) But Asian conglomerate managers are equally wrong when they think they can be successful in any industry they choose to enter. The big Korean firms were all trying to jump into the auto industry although it is one of the toughest industries in the world to enter. The IMF can force sensible restructuring of the conglomerates and a realistic sense of limits.

The IMF can also help countries design the internally based growth strategies that will be needed to replace export-led growth strategies, as with already mentioned changes that would stimulate a surge in residential building in Japan. To allow the Asian countries to export their way out of the current collapse will not be doing them a favor in the long run. The crisis is going to test the effectiveness of the governments of Asia, but it is also going to test the effectiveness of the IMF. Ineffective international agencies wedded to old policies need to be replaced just as much as ineffective national governments.

9.

In the end everyone needs to recognize that the biggest fault line in the world economy has yet to have its earthquake. What we are seeing now are minor earthquakes on the minor fault lines. While it is an axiom of international economics that no country can forever run a large trade deficit that must be financed with international borrowing, this axiom does not apply to a country such as the United States if it provides the world’s reserve currency and can borrow what it must borrow in its own currency. Since it can print dollars there are no risks of default; and in that sense the US isn’t really an international borrower like other international borrowers.

Because it can print the world’s reserve currency, the United States has been able to run very large trade deficits for a very long time. As with a mirror image, this has allowed Asia in turn to run very large trade surpluses for an equally long time. Simple mathematics dictates that no one can have a trade surplus unless someone else has a trade deficit. If America lost its ability to run trade deficits, Asia would lose its ability to run trade surpluses and would face a very large downturn in the demand for its products.

American exceptionalism comes to an end on January 1, 1999, when the Euro is to come into existence. For the first time since World War II there may be a desirable place to go if one wants to get out of dollars. Today each European currency is too small to provide an alternate currency and Japanese financial markets are too regulated for the yen to play that role.

It seems likely that more than a few governments and investors throughout the world are going to want to get out of dollars. European countries and companies with fourteen fewer currency transactions to make will need fewer reserves for transaction purposes. These transaction reserves are now held in dollars or what amounts to dollars. When you read that the Dutch Central Bank is selling gold it is in effect selling dollars. Central banks, such as the Dutch Central Bank, are already reducing their holdings of international reserves. Countries like Saudi Arabia will sensibly want to hold part of their reserves, and price part of their oil, in Euros.

Consider what may turn out to be the choice for those wanting to hold international reserves. One of the possible banks, the American bank, runs a trade deficit of more than $200 billion per year and owes the rest of the world more than $1000 billion. The other bank, the European bank, runs a trade surplus with the rest of the world and is owed money by the rest of the world. In which bank would you rather hold your money?

The American economy is doing well, but foreign investors aren’t buying shares in the American economy. They are seeking to use its currency as a safe resting place for their money. With America’s huge indebtedness and its big annual trade deficit they know that the dollar has to fall sometime. But in the short run no one can be sure. There may be some problems with the Euro. So at the beginning foreign investors won’t move all of their money out of dollars—just some of them will move some of their money in order to hedge their bets. But if enough people hedge their bets and the dollar starts to fall, a run on the dollar could easily begin.

As with all predictable crises, the timing of “the big one” is in principle unpredictable. But if Europe’s plans for the Euro work out, there is good reason to expect it.

—January 6, 1998