Whatever happens next, the Great Asian Slump is already one for the record books. Never in the course of economic events-not even in the early years of the Depression-has so large a part of the world economy experienced so devastating a fall from grace. Latin America, once the world champion when it came to economic instability, has lost the title. Compared with Asia's debacle, the tequila crisis of 1995 now looks like a minor wobble; and the once terrifying debt crisis of the 1980s, a positively placid affair.
Moreover, Asia is nowhere near having hit bottom: While the region's currencies seem to have stopped plunging for the moment, its real economies are getting weaker, not stronger. Hong Kong just announced that its economy shrank 2.8% in the first quarter of 1998, its worst recession since World War II. Economists predict that Indonesia's GDP will fall an astonishing 15.1% this year. Compare that with America's worst postwar recession year-1982-when the economy shrank 2.1%. And it turns out that Japan's bad bank debt is not $550 billion, as previously reported, but a whopping $1 trillion (see following story). The repercussions from all this bad news are just now being felt, not the least of which is a case of the jitters for the U.S. stock markets.
There have already been many recriminations over whom to blame for this catastrophe. Was it punishment for Asian sins or the nefarious work of evil speculators? Did the IMF make the best of a bad situation or did it simply pour fuel on the fire? There is some point to these arguments: Figuring out who lost Asia may help the world keep this crisis, or the next one, from spreading. But the really important question is, Now what? Do we-meaning the IMF, the U.S. Treasury, and the afflicted countries-stick with Plan A, the strategy we've been following so far? Or is it time to try Plan B? And what is Plan B, anyway?
The short answer is that it is time to think seriously about Plan B. And Plan B is fairly obvious-except that nobody, not even Plan A's harshest critics, has been willing to talk about it openly. But before we get to that, let's remind ourselves of how we got here.
Asia: What Went Wrong
By now the outline of how Asia fell apart is pretty familiar. At least in part, the region's downfall was a punishment for its sins. We all know now what we should have known even during the boom years: that there was a dark underside to "Asian values," that the success of too many Asian businessmen depended less on what they knew than on whom they knew. Crony capitalism meant, in particular, that dubious investments-unneeded office blocks outside Bangkok, ego-driven diversification by South Korean chaebol-were cheerfully funded by local banks, as long as the borrower had the right government connections. Sooner or later there had to be a reckoning. Even before the crisis, at a time when foreign banks were still lending and Indonesia's debt was rated Baa, the facade was beginning to crumble: Big Korean companies were going belly-up; Thai finance companies were folding.
But financial excess, abetted by undue political influence, and a morning-after hangover are not particular to Asia-remember those Texas thrifts? The unique aspect of Asia's comeuppance is not the awfulness of the crime but the severity of the punishment. What turned a bad financial situation into a catastrophe was the way a loss of confidence turned into self-reinforcing panic. In 1996 capital was flowing into emerging Asia at the rate of about $100 billion a year; by the second half of 1997 it was flowing out at about the same rate. Inevitably, with that kind of reversal Asia's asset markets plunged, its economies went into recession, and it only got worse from there. The upshot-well, let's quote from the June report of the Bank for International Settlements, an organization based in Basel, Switzerland, that is not usually given to purple prose: "The effects of economic slowdowns, asset price collapses, and banking crises tend to be mutually reinforcing as the curtailment of bank credit depresses asset prices and further deepens recessions. This in turn creates additional problems for banks that are forced to retrench still further. `Vicious circle' has been an overworked term, but it describes Asia's crisis all too well."
So What Do You Do?
In the early days of the Asian crisis, Stanley Fischer-the economist's economist who is also the second-highest-ranking official at the IMF-warned a Hong Kong audience of "the possibility that [speculative] attacks become self-fulfilling prophecies." He worried, for instance, that any attack that forces a devaluation and higher interest rates would also weaken the banking system. In other words, you can't accuse the IMF of being naive: Officials there understood right from the beginning that the vicious circle the BIS so eloquently describes was a possibility, and they tried their best to prevent it.
Working closely with the U.S. Treasury (whose own No. 2 is, of course, Lawrence Summers, another major economics heavyweight), the IMF came up with a strategy that went like this:
1. Lend the afflicted countries money to help tide them over the crisis.
2. As a condition for the loan, demand that they reform their economies, eliminating the worst excesses of crony capitalism.
3. Require them to maintain high interest rates to entice capital into staying in the country.
4. Wait for confidence to return and for the vicious circle to turn into a virtuous circle.
Even in retrospect, this was by no means a stupid strategy. Imagine for a moment that the U.S. had no deposit insurance, and that doubts about a major bank's management had caused a run by the bank's depositors. What would the Federal Reserve do? Well, it would probably lend the bank some cash to meet its immediate needs; as a condition for the loan, demand that the bank president fire his nephew; and tell the bank to try to hold on to its depositors by offering them high interest rates. Then everyone would cross his fingers and hope for the best.
What's more, this strategy worked the last time around. In 1995, Mexico experienced a crisis that, in its early months, seemed worse than the Asian debacle. Robert Rubin and company rode to Mexico's rescue with a large line of credit; the Mexicans moved to shore up their shaky banks; interest rates in Mexico were pushed sky-high; and then all held their breath. It was a terrible year for the Mexican economy, but in the end everything worked out: Money started flowing in again, interest rates fell, and after slumping 6.2% the first year, Mexico staged an impressively rapid recovery.
In other words, Plan A was the natural thing to try. You might even say that it was inevitable: Given not just the economic but the political logic of the situation, and given the success of a similar strategy in Mexico just two years before, how could the IMF and the Treasury not try to repeat their earlier triumph?
While the IMF's response to the Asian crisis may have been a foregone conclusion, that didn't mean that it went unchallenged. From early on there has been a chorus of disapproval, which has left the IMF's public image badly battered. And some of the critics may have been at least partly right-but only some of them, because the critics disagree more with one another than they do with the IMF. Roughly speaking, half of them are hard-money types: people who think that the IMF brought on the crisis by encouraging countries to devalue when they should have kept their exchange rates fixed. The other half are soft-money types, who think that the IMF placed too much emphasis on currency stability. They can't both be right.
Actually, some of them are wrong for sure. The hard-money attack on Plan A, an attack mainly carried out on the opinion pages of Forbes and the Wall Street Journal, and by other supply-side conservatives-amounts to saying that Asian countries should have defended their exchange rates at all costs. To have done this in the face of massive capital flight, however, would have meant drastically reducing the quantity of money in circulation producing extremely high interest rates, far higher than what the countries have had to impose. And a central bank that can't print money because it is required to keep the exchange rate fixed can't act as a lender of last resort, providing cash to local banks threatened with runs. (Argentina, whose "currency board" and one peso/one-dollar policy are much lauded by conservatives, could only watch helplessly as its banking sector started to implode in 1995; luckily the World Bank came to the rescue.)
If you ask the hard-money types why they think their plans would have worked, why they wouldn't have produced a worse catastrophe, the only answer you get is that if only Thailand hadn't devalued, or if Indonesia had established a currency board, confidence would have returned, and everything would have been all right. Well, maybe-but it's a completely circular argument. After all, any economic plan for Asia would have worked if it had instantly restored confidence. Why not skip the currency board and simply tell people to smile more often?
And for those who think that this crisis wouldn't have happened if only we had been on the gold standard, remember that the last time most major currencies were tied to gold was in 1929 ...
The soft-money critics of the IMF, like Harvard's Jeffrey Sachs-who think less emphasis should have been placed on currency stability-had a better case. They argued-correctly-that the high interest rates the IMF was demanding of countries would cause severe recessions and financial distress, and that as a result even healthy banks and companies would eventually collapse. So instead of insisting that countries raise interest rates to defend their currencies, they thought the IMF should have told countries to keep interest rates low and try to keep their real economies growing.
That advice sounds pretty good, so it's important to understand why smart people like Fischer and Summers didn't take it. For starters, the way the advice was given-wrapped in vitriolic accusations that the IMF was both secretive and incompetent-didn't help. More important, however, the soft-money critics never explained what was supposed to happen to exchange rates. In late 1997 the Korean won lost half its value in a matter of weeks. Wouldn't it have plunged even further, perhaps even gone into free fall, if Korea hadn't raised interest rates? And wouldn't that have risked spurring a hyperinflation-not to mention instantly bankrupting all those banks and companies that had large dollar debts?
These questions never got a clear answer. Jeff Sachs has at times seemed to suggest that lowering interest rates would have strengthened rather than weakened Asian currencies-that even though investors would have received lower rewards for holding won or bahts, the prospective improvement in the state of the real economy would have-you guessed it-restored confidence. At other times he has simply seemed to argue that while the currencies would fall, they wouldn't fall all that much, and little harm would be done. Well, maybe-but as of last autumn that didn't seem as good a bet as Plan A.
And so Plan A it was. But things have not gone too well.
Why Plan A Hasnít Worked
Last autumn nobody imagined that Year One of the Asian crisis could be worse than 1995 in Mexico. But it was: Indonesia is a wreck, and there are few rays of sunshine even in the IMF's obedient client states. What went wrong? Here's a partial list:
IMF mistakes. The IMF clearly got some of the details wrong-and some of those details were pretty big. It insisted that countries cut spending and raise taxes, a gratuitous deflationary policy that worsened the recession and the situation.
Too much leverage. Mexico was able to go through a year of interest rates that ran as high as 75% and survive. Asia's economies, it turned out, were more vulnerable because their corporations were much more highly leveraged. When your debt is four or five times your equity-an unheard-of ratio in the West but standard practice in South Korea-it doesn't take very long for recession plus high interest rates to wipe you out. Japan. The world's second-largest economy-a country with a stable government, no foreign debt, and no inflation-should have been a locomotive for its neighbors, the way the U.S. was for Mexico. Instead, Japan has been very much part of the problem.
For all these factors, and maybe for other reasons we still don't understand, the past year has been almost unimaginably bad. It is true that the wild currency swings of last year have subsided and that currencies have stabilized enough for some Asian governments to try to cut interest rates a bit, but those rates remain far too high to jumpstart their devastated economies. At the same time, the double squeeze of high interest rates and depressed economies is steadily driving even the best-managed companies into bankruptcy.
So what's left of Plan A? Well, Korea and Thailand are proceeding with bank cleanups along the lines of America's savings-and-loan rescue. That is definitely a good thing-but it is not at all clear why it should help promote short-term recovery. (Unless-you guessed it again-it restores confidence.) Anyway, given the deeply depressed state of their economies, bank reform is chasing a moving target: Good loans are turning into bad as you read this. Otherwise, the plan seems to have degenerated into one of waiting for Godot: buying time in the hope that something good will eventually happen.
And it might. Maybe Japan's new Prime Minister will astonish the world by devising a massive stimulus plan that pulls not only Japan but also the whole region out of its slump. Maybe there will be a spontaneous shift in investor sentiment, and money will move from Internet stocks to Asian bonds. Maybe-well, maybe the time has come to think seriously about Plan B.
What Is Plan B?
The hard-money types have been surprisingly quiet about Asia's predicament: They make occasional declarations that none of this would have happened if their advice had been taken, but they don't seem to be making any suggestions about what to do now. The soft-money types are more forthcoming: As always, they insist that Asian countries must cut interest rates in order to have a chance at recovery. And they're probably right. The problem is that the original objection to interest rate reductions still stands. As Stan Fischer recently put it, "I can't believe that serious people believe that without temporarily increasing interest rates, we could have contained the problems" of plunging currencies. In late June, Bob Rubin toured Asia urging countries to stick to their tight money policies, presumably fearing that if they didn't, the region's currencies would again go into free fall.
In short, Asia is stuck: Its economies are dead in the water, but trying to do anything major to get them moving risks provoking another wave of capital flight and a worse crisis. In effect, the region's economic policy has become hostage to skittish investors. Is there any way out? Yes, there is, but it is a solution so unfashionable, so stigmatized, that hardly anyone has dared suggest it. The unsayable words are "exchange controls."
Exchange controls used to be the standard response of countries with balance of-payments crises. The details varied, but usually they worked something like this: Exporters were required to sell their foreign-currency earnings to the government at a fixed exchange rate; that currency would in turn be sold at the same rate for approved payments to foreigners, basically for imports and debt service. While some countries tried to make other foreign-exchange transactions illegal, other countries allowed a parallel market. Either way, once the system was in place, a country didn't have to worry that cutting interest rates would cause the currency to plunge. Maybe the parallel exchange rate would sink, but that wouldn't affect the prices of imports or the balance sheets of companies and banks.
If this sounds too easy to you, you're right. Exchange controls present lots of problems in practice. Aside from the burden of paperwork and bureaucracy involved, they are surprise!-subject to abuse: Exporters have an incentive to hide their foreign exchange receipts; importers, an incentive to pad their invoices. Every country that has tried to maintain exchange controls for an extended period eventually finds the accumulating distortions intolerable, and there is a virtual consensus among economists that exchange controls work badly.
But when you face the kind of disaster now occurring in Asia, the question has to be: badly compared with what? After Mexico imposed exchange controls during the 1982 debt crisis, it went through five years of stagnation-a dismal result, but when your GDP has contracted by 5%, 10%, or 20%, stagnation looks like a big improvement. And think about China right now: a country whose crony capitalism makes Thailand look like Switzerland and whose bankers make Suharto's son look like IP. Morgan. Why hasn't China been nearly as badly hit as its neighbors? Because it has been able to cut, not raise, interest rates in this crisis, despite maintaining a fixed exchange rate; and the reason it is able to do that is that it has an inconvertible currency, a.k.a. exchange controls. Those controls are often evaded, and they are the source of lots of corruption, but they still give China a degree of policy leeway that the rest of Asia desperately wishes it had.
In short, Plan B involves giving up for a time the business of trying to regain the confidence of international investors and forcibly breaking the link between domestic interest rates and the exchange rate. The policy freedom that Asia needs to rebuild its economies would clearly come at a price, but as the slump gets ever deeper, that price is starting to look more and more worth paying.
You don't have to agree that the time has come to adopt Plan B-or even that it will ever come-to admit that something like this is the obvious alternative to the current wait-and-hope strategy. And yet it is very hard to find anyone, even among the IMF's critics, talking about it. How come?
The Nonconspiracy of Silence
It's no surprise that the IMF and the U.S. Treasury haven't said anything about alternatives to the current Asian strategy. The key players are neither stupid nor doctrinaire, but as a political matter they must of course always express complete confidence in whatever harsh medicine they prescribe. Moreover, even to hint at the possibility of exchange controls might itself cause capital flight and force Asian countries to raise interest rates rather than lower them. In other words, Plan B is like a devaluation: Officials always deny firmly that they would even consider the possibility of such a thing until the moment they do it.
This gag rule applies not only to officials but to anyone who is associated with the strategy: bankers, major institutional investors, and so on. There is even some self-imposed moral pressure on those who have no policy role but are nonetheless broadly sympathetic with the policymakers and their dilemmas. Consider, for example, the situation of an economics professor and sometime journalist who has known Fischer and Summers all his professional life, wishes them well, and understands why they initially tried Plan A. As you might imagine, he would be very reluctant to go public with his doubts-say, to suggest in a major business magazine that the time has come for Plan B-unless he was pretty definitely convinced that Plan A had reached a dead end.
What is surprising is that neither the Western critics of the IMF nor the Asians themselves have talked much about how to cut interest rates without sending currencies into a free fall. Again, some of these people are very smart, and the thought that it might be necessary to resort to temporary exchange controls must have crossed their minds. Why not say so? One suspects that considerations of salesmanship may be playing a role. Cutting interest rates sounds very appealing; imposing exchange controls, with their deservedly unsavory reputation, does not; so maybe the thing is to emphasize the positive and worry about the unpleasant corollaries later.
And for the Asians themselves, the whole reversal of fortune may simply have been too much to take onboard at once. Barely a year ago these were the economies of the future; to admit that they may need to turn back the policy clock, to implement the kinds of emergency measures that the Latin Americans adopted during the 1980s, may be more humiliation than they can stand just yet.
Can you really blame them? If Asian nations did adopt currency controls, they'd have to brace themselves for an even rougher ride. Any chance of attracting new foreign investment would disappear. The financial markets would probably go into another swoon. But the damage, though painful, would be only temporary. As interest rates fell, local economies would eventually recover, confidence would return (for real!), and those nasty currency controls could be dropped-one hopes forever.
But if Asia does not act quickly, we could be looking at a true Depression scenario-the kind of slump that 60 years ago devastated societies, destabilized governments, and eventually led to war. Extreme situations demand extreme measures; it's time to talk about Plan B.
Originally published, 9.7.98