Strategy for Rapid Recovery in East Asia

By Garry Jacobs and Robert Macfarlane 1

February 4, 1998

Déjà vu -- The financial crisis in East Asia is a replay of America’s Great Crash in 1929. Economic depression and a slow, painful recovery are not inevitable, if we draw appropriate lessons from the past.

Rapid economic development led to rising incomes and rising levels of confidence in the economy. Government supported growth with loose monetary policies and lax control of banking activities. Attracted by the lure of quick profits, investors plowed billions into stock markets and real estate ventures and then borrowed billions more in short term loans on thin margins. Overladen with surplus cash and seeking higher rates of return, banks rushed to lend more money, which fueled a spiraling of prices and short-term profits. Lack of transparency made it difficult to assess the magnitude of the debt accumulation until it was too late.

At one point, somebody awoke to the fact that prices were too high and decided to cash in. Others followed suit. As more and more investors began to sell, prices fell and market sentiment reversed. The change of direction began slowly and then became an avalanche. Panicked by the declining value of the assets they financed, banks tightened credit and stopped giving new loans. Cutting off the flow of cash only accelerated the downward spiral. In reaction, monetary authorities tightened credit to banks, leading to a severe contraction of the money supply. Interest rates soared. Investors were forced to sell short in order to cover loan payments. Defaults and bankruptcies skyrocketed. Prices plummeted. Government, investors and bankers lost confidence in the economy. Financial and real estate markets collapsed, threatening the viability of the entire financial system.

East Asia in 1997? USA in 1929. This is a description of events leading up to the Great Crash, the run on the American banking system, the collapse of nearly 9000 US banks and the Great Depression. These events are remarkably similar to those that precipitated the recent financial crisis in East Asia, except that in this case most of the money used for speculation was provided by foreign banks.

In both cases the initial strategy employed to resolve the crisis -- tighten the money supply and bank credit -- only served to aggravate it. It is now widely accepted that the tight money policies enforced by the US Federal Reserve to shore up the banking system after the Crash plunged America into the Great Depression.

So what have we learned during the past six decades? Judging from the behavior of national governments, international banks and financial institutions – not much! As then, so now national financial authorities and international lending institutions have imposed a set of extremely reasonable sounding conditions on banking activity. Stop speculative lending. Increase transparency and disclosure practices by the banks. Call up and write off bad loans. Cut off credit to bankrupt or endangered enterprises.

These actions appear, as we said, extremely reasonable, but they are counterproductive and potentially devastating. They appear reasonable when we accept a banker’s or monetary economist’s view of the crisis. They are devastating because they repeat the same error that caused the crisis in the first place. That error is to believe that the problem is all about money. Too much money was lent and invested in the wrong things. So now we have to reverse the initial error by tightening credit.

This logic is likely to be no more successful than US Federal Reserve actions in the early 1930s or the IMF program for rapid transition in Eastern Europe. Both led to prolonged and unnecessary suffering. The IMF policy in Russia did eventually halt hyperinflation, but only by reducing the nation’s GDP by 50%. Asking everyone to reduce personal consumption by half can hardly be called a remedy for high prices. The same error is being repeated today in East Asia where credit is so tight that productive economic activities are being strangled, including the export oriented business that experts say will enable these countries to work their way out of the crisis.

Monetary policy is an extremely crude and clumsy instrument. It does not distinguish between the speculator and the producer. It is a partial instrument that can be used to control money supply but cannot be used to effectively guide or direct the whole economic system. Money is only a part of economy, which is itself only a part of society. Exaggerated reliance on a partial instrument will destroy as much as it preserves.

Then what is the alternative? The focus must shift from the part to the whole. The search for a viable alternative has to begin by recalling the underlying reality on which all our financial activities are based – the productive economy. The problem arose because exuberant investors and bankers, both domestic and international, lost sight of the connection between money and productive investments. They caught the fever of high speculative profits and went after the fast buck. Investments were made, loans were justified because the value of the assets acquired was going up. No further rationale was demanded. It did not matter that asset values were rising simply because more money was chasing these assets. As long as they rose, investments were justified -- until the bubble burst.

So far most economists and bankers would agree. But here we depart from conventional wisdom. If it is true that an irrational and unjustified confidence supported by greedy bankers and investors spurred the speculative boom, it is equally true that an irrational and unjustified loss of confidence supported by panicky bankers and investors seeking to cut their losses is now driving down the value of East Asian currencies to levels ridiculously below the true economic strength of these nations. If the speculative fever was a mistake, then the panicky abandonment of these economies is equally a mistake. Reversing the actions that caused the crisis will only aggravate it. Both behaviors arises from the same misconception.

President Roosevelt was not an economist. But he understood some basic facts of life. The tremendous prosperity achieved by the US during the 1920s was not a mirage. It was based on a tremendous growth in national production and productivity. The mirage was only the unrealistic desire of speculators to multiply their wealth faster than the nation’s economic development would support.

In early 1933 American citizens formed long queues outside US banks waiting to withdraw their savings before the banks collapsed. Roosevelt’s first act on becoming President was to order a ten-day closure of the nation’s banks. He then got on the radio to address the nation in the first of his famous fireside chats. He asked the people what had changed that a nation growing so rapidly and so confident of its future should so suddenly lose all confidence in itself and its capacities. He pointed out that the same conditions that had led to American prosperity in the previous decade were still present – the rich natural resources, the productive factories, the skilled American workforce. He reminded the people that the nation’s underlying economic fundamentals were strong and called on them to reject fear and panic. When the banks opened again, long queues again formed outside the banks. But this time the people came to redeposit their funds and express their confidence in the system. The panic stopped. Bank failures declined by 98%. Had Roosevelt and the Federal Reserve applied the same logic throughout the 1930s, the nation’s recovery would have been much more rapid than it actually was.

The recent financial crisis that has befallen the East Asian economies demonstrates the inadequacy of current theories of economic development. How is it conceivable that nations that were heralded as ‘economic miracles’ just a year ago could so quickly turn into patients diagnosed with serious economic disorders? Experts who not long ago were predicting high growth rates for these countries through the remainder of the decade are now saying it may take half a decade or more for them to recover from the devastating effects of the crisis.

A slow recovery from the East Asian crisis is not inevitable. The crisis is not the result of inescapable economic forces. It arose because of a fundamental confusion regarding the real basis and driving force for economic development. This confusion centers on the role of money in economy. Money is an instrument created by society (i.e. human beings) to facilitate economic transactions in much the same way that roads facilitate physical movement of people and goods and the Internet facilitates exchange of information.

Many economic problems have arisen because economists, policy-makers and investors mistake an instrument of economic development for the central reality and determinant. The underlying economic fundamentals of these nations are sound and their future prospects are bright. The public, both domestically and internationally, has lost sight of the real factors – the high levels of social energy and dynamism, the high levels of education and productive skills, and the capacity of these economies for rapid expansion that made them so successful and attracted so much international investment in the first place.

This realization is the starting point for recovery. Even if the problem has been aggravated by self-serving foreign banks, the solution has to begin at home. It will do no good to blame foreigners or depend on them to salvage the situation. The governments and people of Thailand, Korea and Indonesia have to vote confidence in themselves and begin implementing policies that reflect that confidence. If they do, it will not take long for foreign investors to admit the obvious – their currencies and their economies are grossly undervalued.

Governments, banks and businesses must have the courage to reject the facile mirage of conventional wisdom and base their actions on a more real, enduring and fundamental economic reality. They have to come forward to do all they can to shift the focus from money to the productive capabilities of the people, which is the true basis and center of the economy. They need to formulate and implement pro-active programs to stimulate real economic activity and job creation, not to strangle them.

Unlike the Latin American financial crisis of the 1980s, the US savings and loan debacle, the Japanese financial bubble and the East Asian financial crisis were not the result of excessive government spending. In all three cases it was the private sector that borrowed and spent beyond its means. In each case the problem can be traced back to inadequate regulation of the financial sector.

Between 1990 and 1997, capital flows into East Asia rose from $50 billion to over $150 billion. These countries did not possess the institutional mechanisms needed to monitor and control private inflows of this magnitude. Their systems lack the transparency, oversight and risk assessment capabilities needed to avoid excessive borrowings by local banks and private firms. This situation was aggravated by collusion between bureaucrats, banks and private firms. Freedom from political influence is essential for building a sound regulatory system. This is an opportune time for these countries to put in place regulatory mechanisms similar to those of the advanced industrial nations.

What is true for these countries is also true for the global economy. The growth of international institutions has not kept pace with the explosive growth of international monetary transactions. International currency transactions now exceed $1.8 trillion per day, but the mechanisms for regulating international transactions are even less developed than at the national level. The natural course of events is for trade to grow first and the institutions to support that trade later on. International efforts should concentrate on building the institutional infrastructure needed to effectively monitor and regulate global financial transactions.

There are other factors that contributed to the East Asia financial crisis. Their relative importance will be debated by experts for decades to come. The sudden rise in competitive exports by China, excessive lending by Japanese banks seeking higher rates of return overseas, and the strengthening of the US dollar which led to unrealistic exchange rates for dollar pegged currencies – each of these factors aggravated the situation. But underlying them all was the simple fact that financial activity in these countries exceeded the capacity of their economies to absorb productively and of their governments or international financial institutions to monitor and regulate effectively.

The situation in East Asia can be turned around rapidly if the policy-makers endorse this perspective, take concerted steps to plug the loopholes in the present system and upgrade their institutions to Western standards. The right actions have to be based on the right perspective, otherwise they will yield only minimal results.

It is people that create economies and determine at every moment how they function. People create economic crisis and people can resolve them. Willy Brandt was justified when he wrote in his forward to the Brandt Commission report "We retain the hope that problems created by man can be solved by man."



1. Research fellows at the International Center for Peace & Development, USA and The Mother’s Service Society, Pondicherry. Based on a paper presented at the Pacific Rim Conference of Allied Economic Organizations held in Bangkok, January 13-18, 1998.