13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (10 page)

However, another common feature of emerging market crises is that they don’t last forever. Even while outside observers are still despairing over corporate governance, macroeconomic management, and crony capitalism, growth picks up again. In 1999, the Korean economy grew by 11.1 percent; the Russian recovery took slightly longer, with growth of 4.5 percent in 1999 and 11 percent in 2000; and while growth took longest to resume in Indonesia, by 2000 its economy was expanding at close to 4 percent per year.
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A lower exchange rate boosts exports, widespread unemployment reduces the cost of labor, and companies with rescheduled debts or new companies with clean books can take advantage of both higher sales and lower costs. Surviving businesses can use their increased market shares and reaffirmed political connections to grow bigger and stronger. The oligarchs who run them can become even wealthier; Carlos Slim bought up companies on the cheap after the 1982 crisis in Mexico and used the boom-bust cycle of the early 1990s (and his strong political connections) to consolidate his dominant position in telecommunications—becoming one of the world’s richest men in the process.
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Growth can come back without any real fundamental reforms. Foreign lenders learn exactly the wrong lessons from a crisis: they learn that when push comes to shove, the IMF will protect them against the consequences of their bad investments; and they learn that it’s always best to invest in the firms with the most political power (and hence the most assurance of being bailed out in a crisis), perpetuating the pattern of crony capitalism. As a result, foreign capital flows back, and emerging markets can repeat the boom-bust-bailout cycle for a long time, perhaps indefinitely.

But long-term economic growth is unlikely to result. Although oligarchies may be consistent with episodes of growth, they are not good at supporting the development of new entrepreneurs and the commercialization of new technologies.
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In fact, entrenched economic elites may have an interest in limiting competition from new ideas and new people. Political elites, dependent on those economic elites for support, are unlikely to adopt policies to increase competition. Without a business environment that promotes innovation and competition from new entrants—like the one enjoyed by the United States early in the nineteenth century—periodic episodes of debt-fueled expansion do not add up to sustained economic growth.

Fundamental reform requires more than rearranging the seats on the government lifeboat; it requires weakening the economic and political power of the oligarchs and creating a healthier, more competitive economic system. This is only possible for a government with an independent base of support and legitimacy strong enough for it to challenge the economic elites. These are tough conditions to achieve, but not impossible ones, as the Korean case shows.

Korea had the advantage of a serious reformer, Kim Dae-jung, winning the presidency a month after the crisis hit.
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Kim had fought for years against the previous regime and its backers and was deeply skeptical of the chaebol and the claim that they needed special treatment. He had numerous allies, including the prominent People’s Solidarity for Participatory Democracy, which lobbied hard for corporate governance reform as a way to constrain the chaebol, strengthen the economy, and protect democracy.
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Big companies such as SK Telecom and Samsung Electronics were forced to become more transparent to protect minority shareholders against looting. The government also pushed through reforms limiting the power of the chaebol: they were no longer allowed to cross-guarantee debts within groups, investments across companies within a chaebol were curtailed, the number of affiliated companies within a chaebol was reduced, large companies were required to have outside directors, financial disclosure requirements were strengthened, chaebol control over the nonbank financial sector was restricted, and there was a push to reduce debt levels.
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Although the reforms did not solve all of the problems presented by economic concentration, they did lead to a solid economic recovery. The rapid expansion of 1999 and 2000 was followed by annual growth of 4–5 percent in the early 2000s—a respectable rate for a country as developed as Korea, though slower than during the pre-1997 period. There is an active debate in Korea over whether the post-crisis corporate and political reforms went far enough; the largest chaebol, including Samsung, LG, SK, and Hyundai, still dominate the economic landscape. But the reforms were a step in the right direction, because they addressed the core problem that led to the crisis—concentration of economic power in an elite with the ability to influence the political system.

Ultimately, ending the cycle of debt-fueled bubbles and wrenching crises takes more than an IMF bailout package and a new minister of finance with a Ph.D. from an American university.
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Since emerging market crises are the result of political conditions, sustained growth requires an end to the close relationships between economic and political elites that distort the competitive environment and encourage the misallocation of capital. Making this transition successfully is one of the central challenges for all emerging market economies.

NO WORRIES

Few people, if any, thought that these crises had anything to teach the United States, the world’s richest economy and flagship democracy. The differences between Indonesia or Korea and the United States are obvious: income level, financial system, political track record, and so on. Our most ingrained beliefs run directly counter to the idea that a rich, privileged oligarchy could use government relationships to enrich itself in the good times and protect itself in the bad times. Our economic system is founded on the notion of fair competition in a market free from government influence. Our society cherishes few things more than the idea that all Americans have an equal opportunity to make money or participate in government. There is no construct more important in American political discourse than the “middle class.”

The United States was not untouched by the emerging markets crisis of 1997–1998. In 1998, the most prestigious hedge fund in the world was arguably Long-Term Capital Management, founded only four years before in Greenwich, Connecticut, by a legendary trader, two Nobel Prize–winning economists, and a former vice chair of the Federal Reserve, among others.
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When the crisis broke out, LTCM had about $4 billion in capital (money contributed by investors), which it had leveraged up with over $130 billion in borrowed money.
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It bet that money not on ordinary stocks or bonds, but on complex arbitrage trades (betting that the difference between the prices of two similar assets would vanish) and directional trades (for example, betting that volatility in a given market would decrease).

However, LTCM’s models were based on data gathered under ordinary market conditions. When the financial crisis spread and various markets seized up, it began losing money on many of its major trades, and its capital fell to less than $1 billion. But the real problem was that with LTCM on the verge of becoming insolvent, the banks and hedge funds that had lent it money (either directly or through derivatives transactions) were at risk of losing billions of dollars of their own. Fearing the damage an LTCM failure could do to the financial system as a whole, the Federal Reserve Bank of New York brought together representatives from the largest New York banks and pressured them to find a solution. In September 1998, the banks put in $3.6 billion of new money in exchange for a 90 percent ownership stake in the fund, largely wiping out the existing partners; with the new money, LTCM was able to ride out the storm without causing any collateral damage.

LTCM proved that in the new, globalized world, contagion from faraway emerging markets could spread to the United States. However, it also seemed to prove that any damage could be contained through effective intervention and sound macroeconomic management, without requiring taxpayer money or slowing down the real economy. As the long boom of the 1990s continued and the stock market continued to go up, LTCM soon faded into memory.

U.S. policymakers did draw a number of important lessons from the emerging market crises, outlined by Treasury Secretary Larry Summers in a major lecture at the 2000 conference of the American Economics Association.
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Financial crises were the result of fundamental policy weaknesses: “Bank runs or their international analogues are not driven by sunspots: their likelihood is driven and determined by the extent of fundamental weaknesses.” It was more important to look at the soundness of the financial system than to simply count the total amount of debt: “When well-capitalized and supervised banks, effective corporate governance and bankruptcy codes, and credible means of contract enforcement, along with other elements of a strong financial system, are present, significant amounts of debt will be sustainable. In their absence, even very small amounts of debt can be problematic.” Companies should not be allowed to expect government support in a time of crisis: “It is certain that a healthy financial system cannot be built on the expectation of bailouts.” And in a time of crisis, it was critical to take rapid action to clean up failing banks: “Prompt action needs to be taken to maintain financial stability, by moving quickly to support healthy institutions and by intervening in unhealthy institutions.” The best advice Summers offered was a principle famously associated with Mexican president Ernesto Zedillo during a crisis earlier in the decade: “markets overreact, so policy needs to overreact as well.”

These were all valid conclusions. In summary, they meant that emerging market countries should become more like the United States, with our strong legal institutions, transparent accounting, elaborate bank regulations, and independent political system—or, more accurately, they should become more like the conventional image that we held of our own country.

The idea that a major financial crisis of the type that ravaged emerging markets in the 1990s could originate in the United States was too preposterous to even be conceived of. Two of the crucial ingredients—tight connections between economic and political elites and dependence on fickle short-term flows of foreign capital—seemed completely out of the picture.
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Despite rising debt due to growing trade imbalances, Summers’s argument implied that our superior financial system made high debt levels sustainable. More fundamentally, political economy—the study of interactions between the political and economic systems—was only appropriate for developing and emerging market countries. In countries that had already “emerged,” like the United States, economic questions could be studied without reference to politics. Instead, economic and financial policy presented only technocratic questions, which Summers compared to regulation of air travel:

The jet airplane made air travel more comfortable, more efficient, and more safe, though the accidents were more spectacular and for a time more numerous after the jet was invented. In the same way, modern global financial markets carry with them enormous potential for benefit, even if some of the accidents are that much more spectacular. As the right public policy response to the jet was longer runways, better air-traffic control, and better training for pilots, and not the discouragement of rapid travel, so the right public policy response to financial innovation is to assure a safe framework so that the benefits can be realized, not to stifle the change.

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But in September-October 2008, when Lehman Brothers collapsed and panic seized the U.S. economy, money flooded out of the private financial system in what looked like a classic emerging market crisis.
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In retrospect, it was clear that the run-up in housing prices of the 2000s was a bubble fueled by over-optimism and excess debt worthy of any emerging market. The diagnosis of the 1997 Korean Letter of Intent seemed to apply perfectly to 2008 America (substituting “household” for “corporate”): “Financial institutions have priced risks poorly and have been willing to finance an excessively large portion of investment plans of the corporate sector, resulting in high leveraging. At the same time, the dramatic decline in stock prices has cut the value of banks’ equity and further reduced their net worth.”
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And when the federal government began rescuing major banks presided over by ultra-wealthy executives—while letting smaller banks fail by the dozens—it began to seem as if our government was bailing out its own, uniquely American oligarchy.

In similar situations in the 1990s, the United States had urged emerging market countries to deal with the basic economic and political factors that had created devastating crises. This advice was often perceived as arrogant (especially when the United States also insisted that crisis-stricken countries open themselves up further to American banks), but the basic logic was sound: when an existing economic elite has led a country into a deep crisis, it is time for change. And the crisis itself presents a unique, but short-lived, opportunity for change.

As in Korea a decade before, a new president came to power in the United States in the midst of the crisis. And just like Kim Dae-jung in Korea, Barack Obama had campaigned as the candidate of change. Yet far from applying the advice it had so liberally dispensed to others, the U.S. government instead organized generous financial support for its existing economic elite, leaving the captains of the financial sector in place.