Is the Asian Flu Fatal?

For most of the 1990s, East Asian economies were king, sucking up foreign capital and rewarding investors with handsome returns. Times change. The first signs of trouble came in spring 1997, when currency traders attacked the Thai baht. After belatedly attempting to reform its financial policies, Thailand abandoned its fixed exchange rate in June 1997, prompting the baht to plunge 20 percent. Other countries quickly followed. By November 1997, the International Monetary Fund had announced bailout packages for Thailand, Indonesia, and South Korea. Even the soundest and largest Asian economies were hit hard. Hong Kong, while repelling an attack on its currency, saw its stock market decline 40 percent in October. Japan, which had been deep in deflationary doldrums for the entire decade, saw its fourth-largest trading firm collapse under a pile of bad debt.

The sudden turn of fortune in Asia raises a host of questions: Why didn't anyone see this coming? What does this say about the Asian Way, and the Asian Miracle it supposedly produced? How should the IMF and the United States respond to the crisis?

While the first two questions make for interesting cocktail party chat, the last has been dominating discussion in Washington, where the Clinton administration is asking Congress to pony up $18 billion for the IMF's bailout fund. The debate over the IMF hinges on the relative harms posed to the international economy by "systemic risk" or "contagion" vs. the damage of "moral hazard." Proponents of the IMF argue that its virtue lies in the necessity of having an institution that can inoculate a region against "contagion" if a nation's economic system threatens collapse. As with the bank runs that took place in
the United States during the Great Depression, if a country defaults on its commercial loans, investors may panic and pull their money from other countries in the region. Even though these national economies are fundamentally sound, this withdrawal causes a liquidity crisis as banks become unable to pay depositors; unless a third party such as the IMF steps up to provide needed cash ("liquidity"), the system can collapse.

Yet this risk must be weighed against the "moral hazard" the IMF creates. People who have insurance against broken legs, for instance, may be slightly more reckless skiers than those who have no health insurance and, in case of an accident, have to pay doctors' fees from their own pockets. In finance, investors will undertake more dicey investments if a portion of the real risk is insured by a third party which guarantees that it will repay investors, no matter how poorly they manage their money. By bailing out countries, the IMF encourages unwise risk taking.

REASON assembled a diverse group of experts to address these questions in mid-February at the American Enterprise Institute in Washington, D.C. James K. Glassman, a Reason Foundation trustee, American Enterprise Institute fellow, and Washington Post columnist, led the discussion. The other participants were Contributing Editor Brink Lindsey, who runs the Cato Institute's Center for Trade Policy Studies and spent seven years as an international trade attorney, representing clients throughout East Asia; Robert Litan, who directs the Economic Studies Program at the Brookings Institution, where he has most recently focused on financial regulation; Sebastian Mallaby, who covered Asian financial markets for The Economist from Japan and is now the magazine's Washington bureau chief; and Allan H. Meltzer, professor of political economy at Carnegie Mellon University, a visiting scholar at the American Enterprise Institute, and a leading critic of the IMF.

James K. Glassman: What is the problem in Asia and how did it come about?

Sebastian Mallaby: The problem in Asia is the collapse of a financial bubble rather similar to the one that we saw collapse in the early 1990s in Japan, where the financial community had got into its head that asset prices would go up only and not down. Property became massively overvalued. Bank lending, collateralized on their property prices, increased massively, to the point that when one of these asset markets went down, the whole packet collapsed.

Brink Lindsey: I see the Asian crisis here as the harmonic convergence of three sets of bad policies that have all come together and come to a head.

First, you have the bubble that Sebastian alluded to. That bubble is the effect of bad policies that led to a coddled, backward, and protected banking sector that was used as often as not as a slush fund for politically influential borrowers.

The second set is the mismatch between monetary policies and exchange rate policies. You had countries that were attempting to peg their exchange rates to the dollar, while at the same time attempting to run monetary policies that were in conflict with that peg. So you ended up with this big spread between domestic currency interest rates and foreign currency interest rates. Thailand, for instance, was paying rates of 14 percent or 15 percent, which were significantly higher than the U.S. prime. It created this suction effect, sucking in foreign capital. Banks could borrow in U.S. dollars and basically print money by turning around and lending that borrowed money at a markup.

The third set of policies is that for all of these Asian banks borrowing, you had U.S., European, Japanese banks lending recklessly because of the moral hazard created by the expectation that if things went sour, the IMF or some international body would bail them out of their troubles.

Glassman: Did the Asian model of command-and-control capitalism help precipitate this crisis?

Lindsey: The Asian miracle really happened. We had irrational exuberance about Asian values and the Asian system and that they could do no wrong, and that everyone over there was 10 feet tall and bulletproof. Now we have a sort of irrational panic that the whole thing was a fraud and it was all just crony capitalism and a completely corrupt system from top to bottom.

The bottom line is, South Korea went from $100 per person income in the early 1960s to European standards of living today. Even in this recent mess, they have gone from 24 times North Korea's GDP per head down to 23 times. So the progress they have made is stunning and enormous.

And I would argue that the progress is due to the extent to which the economies in East Asia followed a few simple pro-market rules. They had decent respect for property rights, they were oriented toward the global economy, and so forth.