In an Uncertain World (37 page)

In certain respects, however, the Asian “miracle” economies remained less than free markets, afflicted by too-close relationships between banks and corporate borrowers and various kinds of self-dealing and protectionism. In some countries, corruption was a serious problem. And most of them lacked financial transparency at the corporate, banking, and government levels, which meant that creditors and investors could be suddenly surprised by the revelation of concealed problems.

In addition to structural weaknesses, in 1997–98 the crisis countries had made themselves considerably more vulnerable to market pressures by locking into fixed-exchange-rate systems, whether formal or informal. They were hesitant to depart from these currency regimes, most importantly because of fear of instability, but also because the promise of relative safety from exchange risk had helped to bring in foreign capital. The trouble was that a currency can stay pegged to the dollar only if economic policies are appropriate and if the markets believe that domestic concerns will be sacrificed to keep the peg intact. Over time, strains almost inevitably build up, as happened in one Asian country after another and later in both Russia and Brazil. And once the market starts to bet that a currency peg will break, it can take enormous commitment and powerful policy measures to convince it otherwise. But letting the exchange rate go is also damaging. All of a sudden, the debts of companies and governments that have borrowed in dollars or other hard currencies became much more burdensome. This “balance sheet” effect, as it came to be called, had a devastating impact on production and jobs in the afflicted countries. And, compounding the difficulties, several of the countries that got into trouble were also undergoing significant political transitions, which diffused the sense of responsibility for dealing with the crisis.

However, the global financial crisis was far from solely the fault of the countries that got into trouble. Many faulted the United States for pressing emerging markets to open up to external capital too fast. It is legitimate to ask whether some of the crisis countries deregulated their capital markets too rapidly and, if they did, how much responsibility the industrialized countries should bear. At the Treasury Department, in particular after the Mexican crisis, we emphasized the need for an adequate institutional framework and appropriate policy regimes in emerging markets. However, in hindsight, that emphasis should have been more intense. Better regulatory infrastructure and stronger financial institutions alongside more open capital markets would have reduced the potential for instability. A great difficulty in doing all of this is developing the credit culture, the trained people, and the internal practices requisite for strong financial institutions.

Absent a crisis, however, I'm not sure a greater emphasis by the United States and IMF on financial market infrastructure would have had much effect on borrowing-country behavior. In practice, most of the countries that suffered from overborrowing had gone out and sought that capital. They had also, in many cases, resisted the entry of foreign banks—which could have provided immediate aggregations of trained personnel and management, technology, and capital to their banking sectors (a view I held while I was still at Treasury, before I joined such a bank myself). And some countries restricted the longer-term investment that could have been a stabilizing force, while encouraging short-term borrowing.

Moreover, there's a danger that arguments for opening financial markets slowly, or in stages, can become excuses for not opening them at all—since tight controls on capital flows are an easier political solution than fundamental financial system reform. I think history demonstrates that freer capital markets are conducive to a well-functioning modern economy, but they do need to be combined with appropriate regulatory systems and sufficiently strong financial institutions.

Although that is my basic orientation, I have some sympathy for those who argue that controls on the inflow, as opposed to the outflow, of short-term investments might sometimes make sense as a transitional device. Chile had some apparent success in reducing reliance on volatile funds through restrictions on the inflow of short-term capital, but it did not use controls to avoid reform. The central reasons for Chile's success were sound policies and a floating exchange rate.

I do believe that a significant share of blame for the crisis should go to private investors and creditors. They systematically underweighted the risks of investing in and lending to underdeveloped markets over a number of years, and consequently supplied capital greatly in excess of what would have been sound and sensible. And that excess capital, in time, fueled the extremes—overvalued exchange rates, unsound lending by domestic banks, and the rest—that led to the crisis. I remember one conversation I had with Anwar Ibrahim, the finance minister of Malaysia, who had a keen analytical mind and was highly regarded in international financial circles. Anwar ultimately had a falling-out with Prime Minister Mahathir and languishes in prison today. But just before that, Anwar said to me, “For every bad borrower, there's a bad lender.” That comment crystallized the issue for me. In New York and Washington, the tendency was often to put all the blame on the policy mistakes of the borrowing countries. In Malaysia and elsewhere in Asia, the tendency was often to put all of it on First World lenders and investors. Anwar understood that the fault belonged on both sides—with economic management in developing countries and with creditors and investors who had poured money in while ignoring problems.

My own experience with financial markets gave Anwar's comment a special resonance. On Wall Street, I had often seen how excesses of optimism undermined sensible approaches to valuation and risk. I remember, at the time of the South Korea crisis, being struck in discussion with a prominent New York banker by how little he and his company knew about a country to which they had extended a considerable amount of credit. That conversation reinforced for me the notion that in extended good times, even major financial institutions can become less sound in their lending practices, making the same kind of mistake that traders and individual investors do. Though the basic hazard of investing in countries with major economic and political problems should have been obvious, the prevailing mentality was to downplay or ignore those risks in the “reach for yield.”

Did the response make the crisis worse?
Many people who shared the view that First World investors bore a significant share of the responsibility for what had happened in Asia were antagonistic toward the IMF for forcing “austerity” programs on developing countries. I think this criticism misses the point. The IMF—and we at Treasury in working with them—sometimes did make mistakes in the technical design and implementation of its programs. In the face of rapidly changing and in many ways unprecedented circumstances, it would be amazing if we hadn't. But by and large, the IMF got it right. What triggers an economic crisis is a loss of confidence. This results from underlying macroeconomic and structural problems as well as an often sudden reevaluation by domestic and foreign investors of the attractiveness of a country as a place to put savings. The cause of the hardship in crisis countries was not the IMF-backed programs but the crisis itself—the fact that capital was fleeing.

A common complaint was that the IMF's programs forced countries to tighten their fiscal and monetary policies, which sent their economies into a tailspin, when they should in fact have followed a Keynesian policy and tried to stimulate growth. A developed country might have sufficient credibility with credit markets to take stimulative measures to fight off recession. Unfortunately, a developing country gripped by financial panic and fleeing capital does not have the luxury of borrowing more or of cutting interest rates without worsening the panic.

In general, a restrained fiscal regime is required because investors dumping a country's bonds are likely to be further spooked by additional debt. The IMF believed that fiscal policy should be tighter to make room for more exports, without inflation, and to counteract the huge costs that would be incurred in cleaning up banking failures. But fiscal adjustment can be overdone, and in a subsequent reexamination the IMF has concluded that, in the Asian crisis, the initial recommended fiscal or budgetary policies were often more stringent than necessary. Officials at the Fund, and many other people, underestimated how much the crisis itself would cause these economies to contract. However, the Fund moved promptly to correct the excessive requirements and evidence is that this did not contribute significantly to the hardship. The economic impact of the fiscal tightening was dwarfed by the effect of capital outflows.

As to high interest rates, I don't think there was any ambiguity, although others disagree. Savers and investors would regain confidence and be willing to leave their money only in a country that would provide a reward for the risks involved and that was committed to fighting inflation. In the short term, higher interest rates did hurt indebted companies and banks. But they were essential for restoring financial stability, which in turn was required for recovery. Moreover, rates could be—and were—quickly brought down once confidence was reestablished. On the other hand, failing to tighten monetary policy during a crisis risked provoking more of a run. Deeper currency declines could, in turn, lead—in a worsening spiral—to higher inflation, more capital flight, and still further exchange rate decline. Either solution—higher interest rates or a weaker currency—can put a strain on indebted companies and banks. But with higher interest rates, the strain would be temporary if a government succeeded in reestablishing confidence. Treasury kept track throughout the crisis of how interest rates compared with pre-crisis levels. Surprisingly soon, the governments in South Korea and Thailand, which addressed their problems convincingly, were able to bring rates back down, even to below pre-crisis levels, and begin the process of recovery.

Critics who argued that “structural” reforms were intrusive and unwarranted said that passing financial market fashions were being treated as imperatives. But attending to the question of what factors were affecting confidence was not just a matter of following the whims of fickle investors. Markets may worry too much, but their worries generally tend to focus on serious issues. It was always difficult to determine which measures were truly needed to restore confidence and put the economy on a stronger path. If we sometimes erred on the side of excessive pressure for reform, that may have been wiser than erring on the other side and being ineffective. As Mexican President Ernesto Zedillo said, “Markets overshoot, so sometimes policies have to overshoot as well.”

Finally, some people who argued against the IMF programs believed that a market panic fed on itself and the problem in many cases was primarily a lack of liquidity. I felt then—and feel even more firmly today—that this was an oversimplification. Experience showed that market confidence, and capital flows from foreign and domestic investors, tended to turn around only when governments implemented reform. Without that, continued and deepening outward flows could swamp whatever money the IMF and others might provide. On the other hand, the combination of official backing and strong reform embedded in the IMF-led approach was able to stem the crisis and eventually spur recovery.

Did the IMF-led “rescues” make future crises more likely?
In Mexico, and again in the Asia-crisis countries, the IMF lent far greater amounts than was its usual practice. In a number of cases, the United States, other governments, and the World Bank lent additional funds on top of that. In capital account crises, where market psychology was often of critical importance, the firepower had to be sufficient to restore confidence. To some of our critics, these large loans only encouraged private creditors and investors to take more risks in emerging-market economies. While I had a lot of sympathy for moral-hazard concerns, I thought they were overplayed. I had never heard anyone say that they had been more inclined to invest in emerging-market economies because of the Mexican support program. Moreover, the surge of money into these markets was matched by a surge of money into a broad range of higher-yielding, riskier assets. In addition, those who argued for smaller IMF packages and greater “private-sector burden sharing”—which I agreed with to the extent feasible—were ignoring the enormous practical difficulties in managing a debt restructuring and the costs of allowing crises to widen.

Have we fixed the system for the future?
At the same time as the IMF, we at Treasury, the Fed, and other governments were dealing with the crisis on a day-to-day basis, we became very focused on a longer-run effort to improve the workings of the global economy—what came to be called the “international financial architecture.” We had begun the reform effort after the Mexico crisis at the 1995 G-7 summit in Halifax, Nova Scotia. But now this took on a new sense of urgency, and in 1998 it developed into a broad effort involving many countries, both industrialized countries and emerging markets. My view of what had caused the Asian crisis carried implications for both response and prevention. If borrowers and lenders are both at fault, why should the borrowing countries, and their much poorer people, bear the entire cost of repairing the damage? My view was that the burden should be shared to the greatest extent possible. This is an issue of fairness but, even leaving that aside, goes to the essential logic of capitalism. To allocate resources efficiently, a free-market system must allow people who take risks and lose to suffer accordingly, so that future decisions will have the best likelihood of being made with due concern for risk. Unfortunately, this theoretical framework did not provide an effective answer to many of the problems we faced in the muddled reality of the actual crisis.

Too often, well-meaning but simple and sweeping proposals for dramatic change in the system weren't congruent with the complex realities we faced. They often ignored market behavior and unintended consequences and tended to focus on only one aspect of crisis. Looked at most broadly, the system needed change that would work practically to strengthen emerging-market economies and make them less vulnerable, to promote better risk management among banks and financial institutions, whose poor judgment had first masked and then exaggerated the underlying weaknesses in many countries, and to improve the international community response to financial crises.