SYNOPSIS: Worries about Financial panics and their regularity even in this era.
There were warning
signs aplenty. Anyone could have told you about the epic corruption--about
tycoons whose empires depended on their political connections and about
politicians growing rich in ways best not discussed. Speculation, often
ill informed, was rampant. Besides, how could investors hope to know what
they were buying, when few businesses kept scrupulous accounts? Yet most
brushed off these well-known vices as incidental to the real story, which
was about economic growth that was the wonder of the world. Indeed, many
regarded the cronyism as a virtue rather than a vice, the signature of
an economic system that was more concerned with getting results than with
the niceties of the process. And for years, the faint voices of the skeptics
were drowned out by the roar of an economic engine fueled by ever larger
infusions of foreign capital. But why am I telling
you what happened to the United States 125 years ago, in the Panic of 1873?
What a financial intermediary
(a bank or something more or less like a bank) does is pool the money of
a large number of people and put most of that money into long-term investments
that are "illiquid"--that is, hard to turn quickly into cash.
Only a fairly small reserve is held in cash and other "liquid"
assets. The reason this works is the law of averages: On any given day,
deposits and withdrawals more or less balance out, and there is enough
cash on hand to take care of any difference. The individual depositor is
free to pull his money out whenever he wants; yet that money can be used
to finance projects that require long-term commitment. It is a sort of
magic trick that is fundamental to making a complex economy work. Why, then, did the Asian
crisis catch everyone by surprise? Because there was a half-century, from
the '30s to the '80s, when they just didn't seem to make panics the way
they used to. In fact, we--by which I mean economists, politicians, business
leaders, and everyone else I can think of--had pretty much forgotten what
a good old-fashioned panic was like. Well, now we remember. Part of the answer may
be that our financial system has become dangerously efficient. In response
to the Great Depression, the United States and just about everyone else
imposed elaborate regulations on their banking systems. Like most regulatory
regimes, this one ended up working largely for the benefit of the regulatees--restricting
competition and making ownership of a bank a more or less guaranteed sinecure.
But while the regulations may have made banks fat and sluggish, it also
made them safe. Nowadays banks are by no means guaranteed to make money:
To turn a profit they must work hard, innovate--and take big risks.
The crisis began
small, with the failure of a few financial institutions that had bet too
heavily that the boom would continue, and the bankruptcy of a few corporations
that had taken on too much debt. These failures frightened investors, whose
attempts to pull their money out led to more bank failures; the desperate
attempts of surviving banks to raise cash caused both a credit crunch (pushing
many businesses that had seemed financially sound only months before over
the brink) and plunging stock prices, bankrupting still more financial
houses. Within months, the panic had reduced thousands of people to sudden
destitution. Moreover, the financial disaster soon took its toll on the
real economy, too: As industrial production skidded and unemployment soared,
there was a surge in crime and worker unrest.
Anyone who claims to fully understand
the economic disaster that has overtaken Asia proves, by that very certainty,
that he doesn't
know what he is talking about. The truth is that we have never
seen anything quite like this, and that everyone--from the country doctors
at the International Monetary Fund and the Treasury Department who must
prescribe economic medicine to those of us who have the luxury of irresponsibility--is
groping frantically for models and metaphors to make sense of this thing.
The usual round of academic and quasiacademic conferences and round tables
has turned into a sort of rolling rap session, in which the usual suspects
meet again and again to trade theories and, occasionally, accusations.
Much of the discussion has focused on the hidden weaknesses of the Asian
economies and how they produced fertile ground for a financial crisis;
the role of runaway banks that exploited political connections to gamble
with other people's money has emerged as the prime suspect. But amid the
tales of rupiah and ringgit one also hears surprisingly old-fashioned references--to
Charles Kindleberger's classic 1978 book Manias, Panics, and Crashes,
and even to Walter Bagehot's Lombard Street (1873). Asia's debacle,
a growing number of us now think, is at least in part a souped-up modern
version of a traditional, 1873-style financial panic.
The logic of financial panic is fairly
well understood in principle, thanks both to the old literary classics
and to a 1983 mathematical formalization by Douglas Diamond and Philip
Dybvig. The starting point for panic theory is the observation that there
is a tension between the desire of individuals for flexibility--the ability
to spend whenever they feel like it--and the economic payoff to commitment,
to sticking with long-term projects until they are finished. In a primitive
economy there is no way to avoid this tradeoff--if you want to be able
to leave for the desert on short notice, you settle for matzo instead of
bread, and if you want ready cash, you keep gold coins under the mattress.
But in a more sophisticated economy this dilemma can be finessed. BankBoston
is largely in the business of lending money at long term--say, 30-year
mortgages--yet it offers depositors such as me, who supply that money,
the right to withdraw it any time we like.
Magic, however, has its risks. Normally,
financial intermediation is a wonderful thing; but now and then, disaster
strikes. Suppose that for some reason--maybe a groundless rumor--many of
a bank's depositors begin to worry that their money isn't safe. They rush
to pull their money out. But there isn't enough cash to satisfy all of
them, and because the bank's other assets are illiquid, it cannot sell
them quickly to raise more cash (or can do so only at fire-sale prices).
So the bank goes bust, and the slowest-moving depositors lose their money.
And those who rushed to pull their money out are proved right--the bank
wasn't safe, after all. In short, financial intermediation carries
with it the risk of bank runs, of self-fulfilling panic.
A panic, when it occurs, can do far
more than destroy a single bank. Like the Panic of 1873--or the similar
panics of 1893; 1907; 1920; and 1931, that mother of all bank runs (which,
much more than the 1929 stock crash, caused the Great Depression)--it can
spread to engulf the whole economy. Nor is strong long-term economic performance
any guarantee against such crises. As the list suggests, the United States
was not only subject to panics but also unusually crisis-prone compared
with other advanced countries during the very years that it was establishing
its economic and technological dominance.
I'm not saying that Asia's economies
were "fundamentally sound," that this was a completely unnecessary
crisis. There are some smart people--most notably Harvard's Jeffrey Sachs--who
believe that, but my view is that Asian economies had gone seriously off
the rails well before last summer, and that some kind of unpleasant comeuppance
was inevitable. That said, it is also true that Asia's experience is not
unique; it follows the quite similar Latin American "tequila"
crisis of 1995, and bears at least some resemblance to the earlier Latin
American debt crisis of the 1980s. In each case there were some serious
policy mistakes made that helped make the economies vulnerable. Yet governments
are no more stupid or irresponsible now than they used to be; how come
the punishment has become so much more severe?
Another part of the answer--one that
Kindleberger suggested two decades ago--is that to introduce global financial
markets into a world of merely national monetary authorities is, in a very
real sense, to walk a tightrope without a net. As long as finance is a
mainly domestic affair, what people want in a bank run is local money--and,
guess what, the government is able to print as much as it wants. But when
Indonesians started running from their banks a few months ago, what they
wanted was dollars--and neither the Indonesian government nor the IMF can
give them enough of what they want.
I am not one of those people who believes
that the Asian crisis will or even can cause a world depression. In fact,
I think that the United States is still, despite Asia, more at risk from
inflation than deflation. But what worries me--aside from the small matter
that Indonesia, with a mere 200 million people, seems at the time of writing
to be sliding toward the abyss--is the thought that we may have to get
used to such crises. Welcome to the New World Order.