In an Uncertain World (31 page)

CHAPTER EIGHT

World on the Brink

I HAD TOLD LARRY SUMMERS—and, more important, myself—that I was probably going to leave the Treasury Department in the middle of the second term, ideally sometime in 1998. As it turned out, two events prevented me from doing that. The first was the yearlong impeachment battle that began in January 1998. I didn't want to make the President's position any more difficult—and whatever I might have said to explain my departure, people would have read my resignation in 1998 in ways harmful to Clinton. My leaving could also have increased the general sense of uncertainty, which might have had adverse economic effects.

The other obstacle to my departure was the Asian financial crisis, an event that began several months before the impeachment conflict with a devaluation of an obscure currency, the Thai baht, in July 1997. From this seemingly unremarkable event in a country few Americans had thought much about since the Vietnam War, there unfolded a major financial crisis. Much of the practical work of handling the crisis fell to the Treasury Department. As Secretary, I was the public face of the U.S. response, and my leaving could affect confidence. With all of Larry's capabilities, the situation clearly called for both of us to remain fully engaged, and we were better off avoiding a change in leadership.

What people generally referred to as the Asian financial crisis was actually a global economic crisis that began in Asia in the summer of 1997 and spread for a period of nearly two years as far as Russia and Brazil. Aftershocks were felt across emerging markets and even in the industrialized world. Viewed in its entirety, this event posed an enormous threat to the stability of the global economy and caused great economic hardship in the affected countries. Here in the United States, in the fall of 1998, capital markets seemed in danger of seizing up. After a Russian default and the near collapse of a giant hedge fund—Long-Term Capital Management, which had bet heavily on a return to normalcy in the global markets—even the market in U.S. Treasury bonds, the safest and most liquid instruments in the world, was buffeted. For a brief period, all but those companies with the best credit were frozen out of the debt markets. This was perhaps the most dramatic of several moments when cascading financial instability appeared to endanger the entire global financial system.

In certain ways, the Mexican peso crisis of 1995 provided a template for understanding what was happening in the crisis economies. But our fears during the Mexican crisis—that a kind of financial contagion would take hold around the world—had not been realized. This time around, that scenario came true. From its beginnings in Thailand, the contagion spread violently and inexorably. But while our stake in what was happening was very great, the self-interest of the United States in dealing with the problem was even less obvious to Congress and to the American public than it had been two years earlier with Mexico.

Looking back with a few years' perspective, I've come to regard the global crisis of those years as more and more important. What happened to the world economy during that period—and, perhaps more important, what didn't happen—leaves us with a sense not only of how much damage was done but how close we came to even greater calamity. Financial markets are driven by human nature and have a propensity to go to excess. This means that periodic financial crises of one sort or another are virtually inevitable. Understanding what happened last time can help us better prevent and respond to crisis in the future. And that has tremendous importance for many people around the world. My primary focus at Treasury was on the financial aspects of the crisis and its ramifications for the American and global economy. But behind the facts and figures were enormous humanitarian costs—as people lost their jobs and their savings and were plunged into poverty in the worst-hit countries.

In each of the countries where the crisis focused with great intensity—Thailand, Indonesia, South Korea, Russia, and Brazil—the issue of restoring confidence, reestablishing financial stability, and returning to economic growth went well beyond the traditional realm of macroeconomics. As we worked with the IMF, the World Bank, and other nations on the unfolding problem, I found myself having to deal with issues that an American Treasury Secretary doesn't typically become involved in—the labor movement in South Korea, corruption in Indonesia, and the good faith of various members of the Russian government. In this kind of situation, distinctions between foreign policy and economic policy blurred, although decision-making structures inside the government (the State Department, the Treasury Department) were still defined by these traditional boundaries. Also, economic policy makers needed to understand all sorts of issues that weren't expected to be part of our purview. In a way, the need for a rapid education in unexpected topics took me back to my days as an arbitrageur, when I would urgently immerse myself in matters I knew nothing about, ranging from the condition of railroad beds to Rhodesian sanctions, that had the potential to affect big corporate mergers.

Of course, my perspective on the crisis remains an American one, based on my experiences at Treasury. As intense as our interactions were, the experiences and reflections of other key players—whether in the governments of other countries or in the IMF—would undoubtedly differ from mine. To me, the events of those years lead to four important points. The most straightforward of these is the international interdependence that results from greatly increased integration of trade and capital markets—and how little understood that interdependence is. I remember Pedro Malan, the finance minister of Brazil, telling me in October 1998 how difficult it was to explain to his people that their currency was under attack and interest rates were higher in part because the Russian Duma had failed to raise taxes. The global crisis underscored the reality that in an economically integrated world, prosperity in faraway countries can create opportunities elsewhere, but instability in a distant economy can also create uncertainty and instability at home. One country's success can enrich others, and its mistakes can put them at risk.

The reality of interdependence leads to a second point, namely the central importance of effective governance, both national and transnational. The familiar framing of conflict between “the government” and “the market” is in many respects a false one. A market economy needs a whole host of functions that markets by their nature won't provide effectively, including a legal and regulatory framework, education, social safety nets, law enforcement, and much more, and that only government can adequately address. Moreover, while we live in a world of sovereign nations, more and more issues are multinational in nature—for example, trade and capital flows, certain major environmental problems, terrorism, and some public health issues—and those too can only be dealt with effectively by government. Beyond this, some people argue that globalization means that national governments matter less, in the sense that forceful imperatives of the world economy take power away from them. To me, the opposite is true. The potential impact of any one country's problems on others means that national governments matter more—an ineffective government in one country can have a damaging impact beyond that country's borders. Moreover, the responsiveness of global capital markets to national economic policy, whether that policy is good or bad, magnifies the impact of government actions.

The third point is that when a crisis of confidence develops and capital starts to flee, neither money nor policy reforms alone can turn the situation around; both are required. Governments need to implement strong reform programs to convince creditors and investors—both domestic and foreign—that staying is in their interest, that growth and stability will return. In many cases this means addressing long-standing structural weaknesses that have finally become unsustainable and a focus of investor concern, such as a weak banking system or corruption. Also, exchange rates and interest rates must move to levels where both savers at home and investors from abroad feel confident of adequate returns going forward. But money is also needed. Effective international response to a financial crisis combines support for strong policies with enough funding to give those policies time to work—to stem unraveling in the markets and to create confidence—while still allowing governments to support essential programs, including social safety nets to protect the poorest. This is where official resources—from the IMF and World Bank and in some cases “bilateral” contributions directly from the governments of the United States and other countries—are also necessary.

The fourth and final point is that the tools available to deal with the crisis were not as modern as the markets. These tools included the resources and policy expertise of the IMF and the World Bank, the deep engagement of the U.S. President and administration and our G-7 partners, bold leadership in a number of the affected countries, and the ability of nations around the world to work together. And together we did eventually succeed in taming the financial market turmoil, but not before the crisis had wreaked great havoc on emerging economies around the world, causing deep hardship for millions of people. Changes were needed in what was called the “architecture” of the international system to deal more effectively with the risks of globalization by improving crisis prevention and response. The IMF, which was at the center of the crisis management, was founded nearly sixty years ago to promote stability in a world of fixed exchange rates where trade, not capital flows, dominated the international economy. It had adapted remarkably well to the challenges of globalization, but much more needed to be done. We expected this reform process—initiated while the crisis was still raging—to be complex and long term. While important progress has now been made, better approaches still need to be developed on a number of issues.

   

THE FIRST FLASH POINT in Asia was the collapse of the Thai baht in the summer of 1997. I say “flash point” because what happened in Thailand might just as easily have happened in a number of other countries. Throughout the developing world, imbalances had been building for the better part of a decade. Since the late 1980s, investment and credit flows from the developed world had been increasing rapidly in response to strong growth and steps toward economic modernization. Many developing countries had privatized state-owned industries and opened their markets to competition. But these flows were also a textbook example of the kind of speculative excesses that can take hold when investors become seized with some idea—whether an irrational idea like the scarcity of tulips or a sound concept such as the transformation of emerging-market countries—and lose their discipline.

Over time, those excesses became increasingly evident. The mentality that prevailed among emerging-market investors and lenders by 1997 was similar to the psychology of stock market investors in a bull market. Less and less thought was given to risk, which meant that credit and investment flowed into economies that still had many shortcomings. These shortcomings included some traditional macroeconomic problems, such as overvalued exchange rates that were effectively fixed to the U.S. dollar and inappropriate fiscal or monetary policy. But they also involved structural weaknesses, such as underdeveloped and poorly regulated financial systems, serious governance and corruption issues in some countries, lack of financial transparency, and various counterproductive regulatory, labor, and trade regulations. Excessive inflows into countries with serious vulnerabilities were an accident waiting to happen. Thailand simply happened to be the first place where that combustible mixture blew up.

Many of the particulars of Thailand's problems in 1997 echoed those of Mexico at the end of 1994. The country had a big current account deficit—its imports greatly exceeded its exports. Thailand was financing this current account deficit with a lot of short-term borrowing, which was then lent by Thai banks and finance companies for long-term projects, including an unsustainable real estate boom. The Thai baht was tied to the U.S. dollar. The dollar had begun to rise in value on the world market in 1995, and as that continued, the baht became more and more overvalued, worsening the current account deficit. Eventually investors became unwilling to continue financing it. Through the spring and summer of 1997, the Thai government repeated another one of Mexico's mistakes: instead of unfixing its exchange rate from the rising dollar and floating its currency, which would have allowed the market to determine the baht's proper level, the central bank tried to defend that value, spending its dollar reserves to buy baht on the foreign exchange markets. Meanwhile, the country's banks and financial institutions were in terrible shape, ridden with bad debts. And because of extensive lending to companies that had dollar debts but little or no dollar earnings, banks as well as their customers were vulnerable to any decline in the value of the baht.

As investors belatedly recognized the risks Thailand faced, capital that had flowed in too quickly flowed out even faster. As reserves diminished, the Thai government could no longer defend the exchange rate and went to the International Monetary Fund for help. Our Treasury team had been closely following the situation during the spring and summer. We discussed Thailand's difficulties at length and felt that the IMF could handle what we viewed at that point as a familiar kind of financial crisis that occurs when an exchange rate gets seriously out of line and a country is importing too much. Thailand's economy had been growing at an average rate of 9 percent per year for a decade. We thought that after the country dealt with this disruption, with some slowdown leading to fewer imports and increased exports, healthy growth would return. And although we were always cognizant of the risk of financial contagion, we didn't rate the probability as very high—in part because the Asian region was still so widely viewed as economically strong and attractive to investors.