International Monetary Policy: The Asian Crisis and Beyond

A Panel Presented on November 12, 1998 at the Federalist Society's 1998 Lawyers Convention by the Financial Institutions Practice Group

Remarks by Professor William Lash, George Mason University Law School: The financial crisis in Asia currently is really the culmination of decades of hands-on government regulation of the region's economies, distrust of foreign capital and competition, a concentration of power in family-owned business and run-amok crony capitalism, and closed financial systems.

In the case of certain countries, like South Korea, the government also has followed a policy of industrial policy—a funneling of capital to certain export industries.

As most industrial policies, this one failed to pick winners and losers. Export entries fell victim to diminishing global returns and demands, leaving South Korea with a manufacturing over-capacity in certain areas.

These factors were not problems, say, in the `80s, when the great Asian miracle was being applauded, because many of the Asian economies kept inflation at bay by pegging their currencies to the U.S. dollar. In addition, export-driven growth strategies spurred the highest domestic growth rates in the world over the past decade.

The prevalent view amongst many economists—I'll say the western economists—is that with the Asian miracle occurred because the region was positioned during the past decade to capitalize on increasing investment flow from Japan and other countries.

As foreign investment capital flooded the Asian economies in the `90s, the value of their currency increased relative to the dollar. In order to maintain their currencies pegged to the dollar, central banks of many of these countries needed to remove some of the currency from circulation.

Normally, you do this by—in the west—raising interest rates, which has the effect of removing currency from circulation and bringing the currency's peg into balance with the dollar.

However, in these particular markets, the banks accelerated domestic monetary supply in an attempt to make exports cheaper. This had a very destabilizing effect, causing the recent major currency devaluation in many Asian countries. The financial crisis assailing these countries is, in many cases, rooted to the fact that economic reform in these various sectors has been uneven.

Although these countries have taken steps to reduce trade barriers, some countries, such as Indonesia, still have very high barriers. Although Indonesia made progress in scaling back government regulations in certain areas, very little progress was made at the root cause of these problems, such as widespread corruption and heavily regulated and heavily protected financial industries.

The problem is not that these countries are too free; it was that they were too closed. We can't pretend this is a surprise. There were actually early warning signs in the Asian financial crisis. During the 1990 to 1996 period, for example, countries affected by the crisis experienced a rate of bank credit which exceeded the growth of GDP. This pattern of excessive bank lending should have been forewarning of future credit quality problems.

Thailand and Indonesia, for example, had bank credit growing by more than 60 percent above the GDP. This rate, by the way, was all available to the IMF. By contrast, in the U.S. for example, the money supply fell relative to GDP during that period.

What happened in America is what happens normally in other western or rich countries. Money and credit should grow with the economy. For almost two decades, almost a generation, it increased twice as fast in Japan as the economy did. That simply suggested that a lot of credit was being extended without a lot of productivity increase and that a lot of projects simply have not paid off.

Additionally, another problem in this situation came from the role of state-owned banks funding state-owned enterprises. In Indonesia, for example, 48 percent of bank assets are controlled by the state; Korea, 13 percent; Malaysia, eight percent; Thailand, seven percent.

Again,where there is state-controlled banks, there will be state-controlled banks not engaging in arm's length transactions with state-controlled enterprises—enterprises that are being targeted in industrial policy. If we have an agenda of promoting automobiles or promoting computer chips out of state-owned enterprise and getting a check from a state-owned bank, it will make the U.S. Export-Import Bank look absolutely stingy.

That, as that appears, is only half the problem. In addition to private commercial-owned banks in Japan, there is a large publicly-owned financial services sector. The post office in Japan is really one of the world's largest banks. Its retail savings deposits are 1.8 trillion dollars, almost half of the GDP.

Eighty percent of that 1.8 trillion dollars is loaned to the government-run trust fund bureau, TFB. This trust fund bureau receives money from public pensions and life insurance schemes, and has outstanding loans of about 2.8 trillion dollars, 65 percent of Japan's GDP.

The TFB program will invest in politically controlled companies and outfits dealing in everything from infrastructure to house-building to small business loans. Many economists believe that a lot of these loans will never be repaid.

You also see that, as part of this growth of lending, and with state-owned enterprises and state-owned banks, a lot of loans are simply not being repaid, but simply being rolled over. As this bad debt continues to be rolled over, your industrial policy is not going to actually push these people into default.

At the end of 1996, east Asia's outstanding international debt was 752 billion dollars. I always like to think of dollars and jobs. If one billion dollars equals 20,000 jobs, think of 752 billion dollars.

This region is the international banking systems' biggest potential liability. The bad loans made by east Asian lenders account, by some estimates, to ten to 20 percent of the total loan portfolio today. Even if the region's financial woes do not worsen, the total cost of bailing out Thailand, Philippines, South Korea, is already going to end up to about 14 percent of east Asia's GDP. And, again, I'm not even getting into Japan or Malaysia.

Japan has another problem—the financial turmoil in east Asia, since one-third of its imports originate in other Asian states and 37 percent of its exports are targeted towards other east Asian countries. Its banks own 250 billion dollars in outstanding loans to east Asian economies.

Compare that to something we can relate to: the Mexico banking crisis several years ago. That was about 12 percent of Mexico's GDP. Compare that to the crisis in the U.S., which was about two to three percent of the U.S. GDP.

Now, who's to blame? How do you solve this? Well, we've talked about, briefly, the hands-on problem of government regulation in those markets, a distrust of foreign capital. When Malaysia first had the problem, they began pointing to foreign currency speculators.

You've got several problems, in a nutshell. Number one, lack of financial transparency. You simply do not have reporting of Asian banks that exists elsewhere. Simply, you don't have the same amount of reporting responsibilities and the same amount of transparency being made in their lending decisions.

Number two, you have a lack of an active market for corporate control. Without adequate legal infrastructure to protect investors and an accurate market for corporate control, investors don't have the adequate legal ability to protect themselves.

Another problem would be an unbalanced or uneven or nonexistent bankruptcy system. Most of these systems favor debtors over creditors, unlike Hong Kong and Singapore, for example. Thailand has bankruptcy foreclosure laws that clearly favor debtors. These laws exist where the government is really in bed with all these companies. In Indonesia, for example, Suharto's family had a piece of every industry. I defy you to find a major industry in Indonesia that was not somehow tied to Suharto's family, cousins, relatives, or in-laws. Obviously, those laws can only be favoring the creditors, which are a part of the cronies of the government.

Finally, there are trade barriers, I'll use Indonesia as a model. Many of the trade barriers were in place to protect industries where the government and their cronies had financial interest.

Now, we have a big interest in the U.S. in keeping this market afloat, both political as well as economic. Helping east Asia recover economically is vital to the U.S. interest.

The financial crisis, if it persists, could slash, by some estimates, 120 billion dollars from the U.S. GDP by next year. Again, think of 20,000 jobs for each billion dollars. We're talking about 120 billion dollars of GDP being slashed from the U.S. by this crisis, not to mention the political ramifications of instability in those markets, particularly Indonesia, which is a large Muslim country and which had a very moderating impact in the Muslim community.

The structural reforms from IMF, et cetera, are only one part of the iceberg. Multi-lateral answers may not be the answer, but, as I say, to quote Shakespeare, "the fault, dear Brutus, lies not in our stars, but in ourselves."

Most of the problems of these countries are the structural reforms that either the IMF has to have in place before they do further lending or, frankly, other lenders have to have required.

Capital restrictions are going to be one of the things proposed in all these markets like Malaysia. They're absolutely the wrong answer. By keeping capital out or making it more difficult for international bankers to invest in the country, they will dry up capital in those markets, making people more reluctant to invest and raise the cost of capital, which in the end will reduce economic freedom in all these societies.

Remarks by Mr. Bert Ely, Ely & Company, Inc.: I want to touch on Japan. Of course, the reason why is because Japan is not only the world's second largest economy, it is by far and away the world's largest planned economy. I want to emphasize that it is much larger than the Soviet Union ever became, four times the size of China's economy, and yet it suffers from many of the same ills.

What I want to do, first, is talk about the Japanese situation today and then talk about where Japan is headed.

Japan is in recession today, the third quarter of recession, and it's going to be in recession for a long time to come. The Japanese government is trying a variety of Keynesian-type techniques to stimulate demand,but, frankly, they are not working. They have spent billions upon billions of dollars in public works activity, most of which are driven more for political reasons than anything else. It represents a substantial waste of Japanese savings, because they're being used to build infrastructure that, frankly, is not needed, particularly in rural areas.

There is some talk now of tax cuts, but the likelihood in Japan is that people will save their tax cuts rather than spend them. As a result, they're not getting stimulus in their economy. That's why Japan continues in recession.

You've read a lot about the banking problems, particularly the fixes to those problems. Let me assure you that they are not fixing their banking problems. That is not the intent. The intent is rather to rock the boat as little as possible. The latest plan that's been put into place, in which there are supposedly going to be several hundreds of billions of dollars of public money invested in the banks, effectively represents a partial to complete nationalization of these institutions.

In some cases, they will be nationalized; in others, the government will take a substantial minority position. It says it will be a silent minority partner. Don't believe that for a minute.

What is important to understand is that—unlike what we did in this country with our S & L problems, where we really genuinely did fix them—Japan is not yet on a path towards fixing their banking problems.

This gets to what is really at issue in Japan today, and that is that it faces a political problem, not an economic problem. Japan has been controlled since the early `50s, with the exception of a brief period earlier in the `90s, by the Liberal Democratic Party, the LDP. The LDP is the party of the bureaucrats. The LDP, in effect, is the protector of the bureaucracy, which is who really runs Japan, as you would expect in any kind of government-planned economy.

So the LDP today is faced with some very serious political problems. Its hold on the country is threatened. It lost control of its upper house, the House of Councillors, in the July elections, in which there was a very strong vote against the LDP in the urban areas.

But because representation in Japan is tilted toward the rural areas, the LDP continues to shower favors upon the agricultural sector, the construction industry, and other sources of its political support.

The LDP is interested in power for the sake of power only. They're trying to hang onto it. The bureaucrats want them to hang onto it, because if the opposition comes into power, as I think they eventually will, then we will see Japan as a planned economy slowly come to an end.

The next elections for the lower house have to be held within the next 23 months. What the LDP is trying to do is to get through this period of time until the next elections, which they hope they can win, by disturbing the financial, economic, and industrial landscape in Japan as little as possible. That is why the intent of the so-called banking fix is not really to fix anything, but not to cause things to come unglued.

But, in fact, they will come unglued, because Japan, despite the fact that it is the world's largest creditor nation, with net claims on the rest of the world of as possibly as much as a trillion dollars, is facing a massive domestic debt crisis.

I emphasize domestic crisis because it is that crisis which is going to trigger reform in Japan. The way to look at Japan is from the standpoint that it has two sectors. The first is its household sector, which has accumulated an enormous amount of savings, upwards of ten to 12 trillion dollars worth of savings. The other is the non-household sector, which is comprise of the public sector, the financial sector, and the industrial sector, all of which are heavily indebted to the household sector.

So the household sector has enormous financial claims, largely in debt instruments, principally in the form of insurance policy reserves and bank deposits, and very little in the way of common stock, which represent claims on the non-household sector that has suffered enormous losses in recent years as stock values have collapsed, as real estate values have plunged, and as losses elsewhere in Asia have come back home to haunt Japanese companies. It was the Japanese companies that fueled a lot of the economic growth through planned expansions elsewhere in Asia.

So the non-household sector is essentially bankrupt. And we are now seeing, in recent months, a lot of earnings reports coming out of some very large Japanese companies that are frankly, very bleak. They are reporting losses for the first time in many years, if not decades. That is going to continue.

What compounds problems further in Japan is that it suffers, like the rest of Asia, from enormous over-capacity. There exists too much in the way of manufacturing and service facilities, which, again, have lost value.

So Japan has a non-household sector that is slowly losing economic value and yet it has a household sector whose claims on the non-household sector have not diminished in terms of number of yen.

That is basically a prescription for bankruptcy and that is what Japan, as a country, is going to go through domestically. Again, not because of pressure from foreign creditors, but because an internal debt crisis that is developing.

Now, how are they going to work out of this? Well, first of all, we must remember that Japan has a political process that is enormously resistant to change, which, again, reflects the Japanese culture. There is a tremendous aversion to job layoffs, plant shutdowns, and the like. People don't want to rock the boat.

The way I characterize Japan, and the political process reflects this, is that it is like a group of people in a car that is speeding 100 miles an hour at a brick wall. The car's occupants know that there will be a crash. They know that the aftermath of that crash will be very painful. But they're enjoying the ride right now, so they keep on going. That is the way to understand what is happening in Japan today.

Now, what we're on the verge of seeing is a crisis, and I cannot emphasize that enough. It is going to be a crisis that will lead to a massive restructuring of the domestic indebtedness in Japan.

What will trigger the crisis? Well, I see three possibilities, all of which are in play right now. First of all is the interbank lending crisis. The Japanese banks, all of them, as a practical matter, at least by American standards , are insolvent. I don't think there is a solvent one in the bunch. They are being steadily cut off from access to the interbank market.

This is a problem for them because they have substantial non-yen assets that they have to fund with non-yen sources of funds. For instance, Japanese banks still have a lot of loans outstanding in this country, many of which are non-performing still. So they have to fund the loans that they've made in dollars, marks, and pounds and so forth and they have to do it in the interbank market.

Well, the interbank market is shutting them off because of the deterioration of the Japanese banking system. We are now seeing, particularly in recent weeks, a phenomena that has emerged called negative interest rates. A lot of economists never thought this could happen. Well, guess what? We have seen it in recent weeks in Japan. It's a shocking event and it arises out of the fact that foreign banks are, instead of lending money to the Japanese banks, selling them dollars in return for yen, which the foreign banks then put right back to the Japanese government by buying short-term Japanese treasury bills.

The banks created such a demand for those bills that they actually have a slight negative yield. But effectively there is an international banking run on the Japanese banking system. It's been underway for months and it's getting worse.

The second is bond rating cuts. Japan is still an AAA-rated country. But two months ago, Fitch IBCA, which is emerging as the world's number three rating agency, downgraded Japan from AAA to AA+. It said Japan has a banking system that is far worse than any other country in the world that is either rated AAA or AA. That's a signal that Japan's ratings will drop further.

Moody's announced several months ago that it has Japan under a ratings review. It will undoubtedly soon cut that rating. What that says is that Japanese government debt isn't very sound.

This will lead to the third possibility, an acceleration of something that's been underway for at least since the spring, and that's a flight of the Japanese citizenry from the yen. This is happening already, to some extent. Citibank, which has a number of branches in Japan, is being flooded with deposits. The real challenge is how they invest those yen

What I see happening is a flight by the Japanese citizen from the yen. Now, they're going to be slow to move on this because they are very risk-adverse. They have a tremendous belief in Japan as a nation.

But at some point in time, Japanese citizens will get fed up holding financial assets that earn maybe a fraction of one percentage point of yield in a currency that faces a substantial loss in value.

And it is going to be that run, coming on top of other events, that will finally force Japan to go through a major debt restructuring. The only practical way this can work out is that the very substantial holdings that the household sector has in Japanese financial institutions will essentially have to get locked in and then be repaid a very low rate of interest to stop a run on Japanese financial institutions.

This, in turn, is going to lead to higher interest rates in Japan, which, of course, will have some adverse effects of its own, but will bring about a convergence of Japan with the rest of the world. It will move Japan towards a market economy.

But, again, the fallout, particularly during the time of this debt restructuring, is going to be very painful. It will have significant effects outside of Japan, particularly as Japan sinks further into recession and as it imports less and tries to export more.

What can we outside of Japan do about that? My sense is we can't do anything except watch it and hang on, because it's going to happen and there is nothing we can do to stop it.

Remarks by Mr. Ian Vasquez, CATO Institute: I will talk about the International Monetary Fund, the IMF, which is actually a very secretive or closed institution, that keeps a low profile, generally, except when there is a crisis in its member countries, when there are riots in the countries that receive its credit, or when it has been seeking additional funding itself.

Unfortunately, those three factors explain why the IMF has such a high profile these days. I say unfortunately because the IMF, in fact, has a very poor record at promoting market reforms in developing countries and at promoting self-sustaining growth in those countries.

Despite its poor record, it has—like any good bureaucracy—proven remarkably resilient as an institution in finding new roles for itself over the years. When, for example, the international system of fixed exchange rates ended in the early 1970s, many economists thought that the IMF would close down because its original function to maintain stability under that system ended.

Instead, the IMF increased its lending five-fold and it has found new missions ever since with each crisis. In the 1970s, it was the oil crisis. In the 1980s, it was the third world debt crisis. In the early 1990s, it was the collapse of communism, trying to get these countries to move toward the market. And since 1995, we have seen that it is performing a bailout function, beginning, first, with the collapse of the Mexican peso.

Now, I would like you to keep in mind that the IMF, in theory at least, makes loans on a short-term basis in exchange for macro economic reforms in the countries that receive its credit.

Well, unfortunately, this has not actually helped countries move toward the market and instead it seems to have created loan addicts rather than actual success stories. We reviewed—at the Cato Institute—the record of IMF lending and found that through this year, 19 countries had been receiving IMF credit for more than 30 years, 31 countries had been receiving IMF credit between 20 and 29 years, and 36 countries had been receiving credit between ten and 19 years.

This is not evidence of the success of IMF conditionality, much less the short-term nature of their loans. The reason we're talking about IMF lending today is actually because of its new function of bailing out countries. I oppose that role, particularly for the IMF, for three reasons.

The first reason is that it creates moral hazard. The more that the IMF lends to countries, the more that we can expect countries to slip into crises in the future. I think that Mexico is a perfect example of that. After all, over the past 20 years, with each election cycle in Mexico, there has been a currency crisis and each time the IMF and the U.S. Treasury Department have come in and rescued Mexico from its own irresponsible fiscal and monetary policies during that election year and each time those bailout amounts have been greater and greater.

In Mexico, everybody expects that at the end of each presidential term, there will be a devaluation and that the IMF will step in. Even though Administration officials have claimed the Mexican bailout a success, it sent a signal to the world that if anything went wrong in emerging countries, the IMF would step in.

So I don't think it was a surprise to see, in 1995, capital flows to east Asia nearly doubling. As a result, governments in Asia were not discouraged actually to change their own flawed policies during this time as long as capital kept flowing.

The second reason I oppose IMF bailouts is because they are a bureaucratically expensive and fundamentally unjust solution to currency crises and to financial crises. IMF bailouts, in the first place, cut investors' losses—those people who were earning handsome profits before the crisis. Just as it's not appropriate to socialize profits during good times, we shouldn't be socializing the losses during bad times.

IMF bailouts pose another problem, and that is that they don't work very well. Giving money to governments that created the problem to begin with and that have shown themselves reluctant or very hesitant to introduce reforms is not a good way of encouraging those reforms. That tends to postpone the introduction of the reforms that everybody wants to see.

It's better to suspend credit and force countries to undertake reforms out of economic necessity. After all, the reason that there is talk of economic reform in Asia today is not because the IMF has arrived and said you need to change your policies. The reason is precisely because of the economic reality that has concentrated the minds of policy-makers in those countries.

To the extent that the IMF steps in under those conditions, it delays reform. So I see the IMF bailouts as posing two burdens on crisis countries. First it imposes additional debt on ordinary citizens who had nothing to do with creating the crises. Second it prolongs the period of crisis by delaying the introduction of those necessary market reforms.

You may be saying to yourself, but what about the fund's strict conditionality that we always hear about? Well, as we've seen from the record of IMF lending over the years, it doesn't seem to have much credibility, but there is another reason why IMF conditionally does not have much credibility.

Remember that a country under an IMF program, especially a highly visible one, that receives IMF credit and then does not complete or perform the conditions under which it agreed, gets its IMF credit suspended. And this is something that we've seen over and over again in the case of Russia.

In other words, if a country isn't complying with the conditions, the IMF will suspend the credit in order to encourage it to introduce market reforms.

Note that the IMF encourages market reforms precisely by cutting off credit and it is precisely at that time, as we've seen over the past six years in Russia, that, in fact, market reforms begin to be introduced. Policy-makers in Moscow begin to take some of those reforms seriously, promise them and actually begin to introduce some of them.

Unfortunately, it is at that point that the IMF begins lending again, based on the promises of future reform. That lending slows the process of liberalization down again and starts the process over.

You see, the IMF simply cannot afford to watch a country reform on its own. It has a bureaucratic incentive to lend. If it didn't lend and the country reformed on its own, the IMF would risk being viewed as irrelevant. This institutional incentive to lend is well known, both at the IMF and at the recipient countries, which makes the conditionality of its loans that much less credible.

The third reason that I oppose these bailouts is that it undermines superior market solutions to financial crises. In the absence of an IMF, creditors and lenders would do what creditors and lenders always do in the cases of insolvency or illiquidity. They would renegotiate their debts or enter into bankruptcy procedures.

This bankruptcy procedure is essential for a market system to work. Jim Glassman has said before that capitalism without bankruptcy is like Christianity without hell. It doesn't work. And you have to have that. Unfortunately, the IMF bailouts tend to undermine precisely that market mechanism which makes capitalism work.

There is just no reason to treat international lenders and borrowers any differently than those at the domestic level. Governments, in a world without an IMF, would also behave differently because in the absence of IMF money, they would have to introduce market reforms. Lawrence Lindsey, the former Fed Governor, also observed that, when he said, that "all of the `conditions' supposedly negotiated by the IMF will be forced on South Korea by the market."

Of course, there is always the possibility that a country without IMF intervention would be reluctant to change under any set of circumstances, but I am suggesting that the possibility is far greater under IMF programs.

The failure and the poor performance of the IMF in the past couple of years has led to a plethora of reforms coming out of Washington and other countries that donate money to the IMF. In the United States, President Clinton has suggested that we start a new financial global architecture. Grand words are being thrown about. Tony Blair said we should have a brand new Bretton Woods conference and so on.

I think there are two tendencies that are going on here. One of them, coming out principally of the U.S. Congress, is an attempt to turn the IMF into a sort of international lender of last resort, whereby short-term loans are made to solvent, but temporarily illiquid institutions.

The IMF, by contrast, lends over the long term to clearly bankrupt institutions at subsidized rates, which tends to undermine precisely the workout mechanisms that a market needs.

The Congress has funded the 18 billion dollars that the IMF has requested throughout the year and, in exchange, it has claimed to receive substantial reforms from the IMF. However, these reforms are based, unfortunately, on promises from the IMF and from other governments who also govern the IMF, that it will make shorter-term loans and it will make them at sort of market interest rates.

I don't know how those would be determined. Moreover, I fail to see how this would serve as an effective lender of last resort. Unfortunately, we can—since the money has already been handed over—expect that these promises are going to be about as credible as the promises that the IMF receives from recipient governments.

So the U.S. Congress' conditionality on the IMF is likely to be just as effective as IMF conditionality has been.

In fact, the IMF is already moving to institutionalize a proposal that President Clinton made during the annual World Bank IMF meetings, and that is to lend to countries as a sort of bailout before a crisis occurs, not after a crisis occurs.

The idea here is to lend to a country so that a crisis doesn't erupt and Brazil, probably today or tomorrow, will receive about a 40 or 30 billion dollar package in an effort to do this.

I think it's worth noting that, in fact, this is not going to be the first time the IMF has done this. It did it in the case of Russia and Indonesia, and then the crisis broke out.

So I think that in the case of Brazil, we're very likely to see this bailout turn into yet another gift to speculators and bankers and so on. And, of course, Brazil is not Russia or Indonesia, but if you look at the reforms that the Brazilian Administration has proposed in exchange for this bailout money, you will find that, in fact, there is nothing in it to convince either investors or, I think, any intelligent observer that, in fact, that's going to solve Brazil's economic problems.

There are other proposals at the IMF, but suffice it to say, the IMF is not reformable. The world would be better off, both more stable and more prosperous, if it were shut down.

Thank you.

Remarks by Mr. William Haraf, Managing Director and Chief of Staff, Banc of America Securities: Listening to Ian Vasquez talk about the IMF is pretty scary. It reminds me of the story about Richard J. Daly, the old Mayor Daly of Chicago, back in 1968, at the Democratic Convention, when he held a press conference and one of the reporters actually accused the Chicago police of starting the riots, and Mayor Daly said the Chicago police aren't there to create disorder, they're there to preserve disorder.

One of the interesting things about this crisis what we've gone through now that started in east Asia is that, going into the mid 1990s, most economists looking at east Asia would say, the fundamentals really look good in these economies: there are generally low fiscal deficits or fiscal surpluses, reasonable monetary policies, low inflation rates, stable exchange rates, and educated and motivated work forces. It's no wonder that these economies developed such a good reputation as the Asian tigers and they grew so strongly.

However, as we all have learned subsequently, if we didn't know it before, the financial systems there were very fragile. Non-bank borrowers were highly leveraged. They were very dependent on banks for their financing. There's a lot of cronyism and government-directed lending.

Major banks were perceived to have the implicit full protection from their governments. And even other private sector borrowers were viewed as either too important to the domestic economy or too politically connected to be allowed to fail.

So the money flowed in and things got bad last year. As a result, one of the main lessons that we learned from this crisis is that sound macro economic policies are just not enough, because this was largely triggered by the inability of private sector borrowers to repay their debts.

The affected countries were simply too highly leveraged, too dependent on external financing to withstand an adverse macroeconomic shock. When they got hit all of a sudden, they were basically just not in a good framework to absorb the risks and deal with them—the risks associated with the way their currencies were being managed, the way their private sectors were highly levered and so on.

Collectively, we had in these situations private sectors that were essentially borrowing short in foreign currencies and lending long in projects that were paying off in domestic currencies.

Despite the impressive track record that these countries had developed over many, many years, and all the reasons to be optimistic about their future prospects, it would have been naive to think that all the borrowers and other market participants were just completely blind to the risk this posed.

Well, how is it that all of the money flowed in? Clearly, moral hazard played a role. Private borrowers in those countries, global lenders and investors—at least some of them—must have believed that these governments were prepared to stand behind their pegged exchange rate regimes and their giant banks, and that if the worst happened, the IMF would step in and, in turn, stand behind those governments so that they could maintain the exchange rate regimes and protect their banks.

Now, in actuality, some of these assumptions proved to be false. With the encouragement of the IMF, countries were forced to devalue and despite predictions to the contrary, a lot of firms were allowed to fail, even financial sector firms, although generally not commercial banks. Commercial banks were protected.

And in the process of these failures and in these devaluations, I think market participants learned some important lessons that will reduce the likelihood of such problems in the future.

That said, of course, more needs to be done. Now, I ask you, since we're all libertarians here, put yourself in the position of a benign reformer just elected to power and you're a libertarian at heart and you're presiding over a country in the midst of this crisis, with an impoverished and politically divided electorate, and you have a mandate to restore your economy and restore economic growth.

But, you know, just as in the United States, there is really no political consensus about which way you ought to go. Should you favor market solutions? You have critics on the right and on the left and you've got a limited amount of political capital to spend—what do you do?

Well, one approach is the one Malaysia took—impose capital controls. You have noted economists, highly respected individuals like Paul Krugman or Jeff Sachs, saying capital controls are the way to go.

But, on the other hand, you're convinced that there is a significant economic cost associated with capital controls. You don't want to do that. You want to keep your capital markets open, because you recognize the investment potential that foreign capital flows can provide, and you know that capital controls are just an invitation to corruption and cronyism and so on.

So instead, you opt to do some other things. The first thing you've got to do is reform your banking sector. You know that that was a big part of the problem. Now, one approach you could take, if you're a real libertarian, is to say I'm going to go a free banking route. I'm going to get the government completely out of the business of regulating banks, and I'm just going to let Bank of America and Citibank come in and run the banking sector.

But, you know, either of those choices has got to be pretty risky for you with the potential for significant transition costs. So maybe opt for a situation in which you think, well, some of my banks may be insolvent, but some really have the potential to get through this thing; I'm going to leave a role for them, ensure that they're well supervised, make sure that they've got the right capital and so on, and then I'm going to also open up my market to foreign banks as well.

The second thing you've got to do is get rid of cronyism in the private sector and make sure that your private sector generally has the right incentives; that it's got governance structures in place that make sense; that it's got accountability; that there are bankruptcy laws, such that if a private borrower gets in trouble, assets are written down and there's a restructuring plan put in place. You've got to do that.

The third thing you've got to do is the transparency part that Bill Lash talked about. In order to regain the confidence of global markets, you've got to make sure that the global lenders and investors have enough information to distinguish between good credits and bad credits. There is an effort in this regard on the way. The international accounting standards committee is establishing accounting standards that they're going to come out with next year. The World Bank is telling the big five accounting firms that they shouldn't be putting their name on audits of private corporations in those countries, unless they're following global_international_accounting standards. You say, well, that's the right approach, I'm going to go down the road.

And, finally, on macroeconomic policy, well, you listen to your libertarian advisors and you've got some guys talking about currency boards, you got some guys talking about pure floating exchange rate regimes, you kind of scratch your head and you say, well, there is no consensus, I'm just going to have to figure out what's best given the situation I'm in.

So it's kind of a muddle-through scenario for a libertarian reformer facing tough choices in the real world. In fact, the kinds of policy choices I've presented to you are the policy choices that the G-7 and the group of 22 are advocating that market economies adopt in order to keep their markets open and strengthen their ability to operate in global capital markets.

In fact, it's the types of policy conditionality that the IMF is imposing in connection with its lending programs. So the group of 22 consists of a lot of important emerging market countries. They have sort of endorsed, in principle, the concepts that I have just outlined.

But it's one thing for emerging market countries to endorse these principals. It's quite another to have the resources and political will to implement them, because after all, these things are politically tough choices for governments and they entail significant economic transition costs, not to mention the fact that they really have adverse effects on important political constituencies.

So I guess the role that I would like to lay out for the IMF and the role—the direction in which the group of seven is intending to push the IMF—is a pragmatic move toward strengthening an economy to put it in a better position to operate in the global financial marketplace of today.

It's probably not what the libertarian reformer model would want to put in place himself, but the fact is it's nudging these economies in the right direction and it seems to me that's the best case for doing what the IMF is trying to do today.

Now, I kind of feel like the skunk at the garden party here, trying to defend the IMF, but I will say one last word about it, especially since I'm a libertarian myself. But I will say, also, with respect to this new proposal that President Clinton put on the table and which the G-7 subsequently endorsed for the IMF to create this new line of credit contingent on certain policy conditions on these countries that there are good reasons to be wary about it, because it does create a lot of potential for moral hazard.

However, I think, once again, if you were trying to figure out a way to get the IMF to deal with the world it's operating in today, how would you design an IMF? You'd put it in a situation where it's setting up its policy conditionality ex-ante rather than ex-post.

That is, ideally, you would want to say, look, if you want to be eligible for loans from the IMF, you have to have a banking sector that is sound, supervised and so forth. Your private sector borrowers have to conform to internationally accepted accounting principles. You have monetary and fiscal policies in place that are appropriate for your circumstances, and so on, and if you meet all of those conditions, then we'll make you eligible for the line. If you don't meet those conditions, we're yanking the line.

Now, I think that's sort of a theoretically reasonable approach to take. The question is whether or not, in reality, that's the way it's going to work. We're going to get our first test of this policy conditionality approach with this Brazilian package that's going to be announced soon and my guess is that the types of conditions that the IMF is going to impose in Brazil are not nearly going to be as tough as the conditions ought to be over the long term.

But I hope that the IMF will take this as an opportunity to move in the right direction and to strengthen the type of conditionality that it will impose as a requirement for access to this contingent facility.

Closing Remarks by Bert Ely: With that, I want to end on some good news, and that is that what is going on in the world, particularly in east Asia, is that we're seeing the final crumbling of state-directed capitalism in all the various forms that it took.

It collapsed first where it was weakest, which was in the former Soviet Union and eastern Europe, but, frankly, Asia had a model that looks a lot more like the Soviet Union and communist China than the U.S.

Asia has market economies only in a very limited sense and largely market economies in terms of their relationship with the rest of the world.

But because of the fact that electronic technology is creating a truly global capital market that nobody can really control, at least for the foreseeable future, we're seeing market forces slowly undermine and destroy state-directed capitalism.

Now, it's a very messy process, as we've seen over the last ten years, and frankly, it's going to get a lot messier over the next five years, particularly if Japan ends up in a state of crisis, as I think it will.

But as dark as that may look, what that crisis represents is a crumbling of the old statist order and a real—not just a resurgence—increasing domination of market forces with regard to capital flows, which ultimately affect all aspects of the world economy.

So what's going on right now is very positive for the long term. The challenge is getting through the short and medium term.


2001 The Federalist Society