(April 8th, 1998)

By André Lahóz

Translation by Peter Bartl. Thanks!

Some context on this article might be helpful. It took place after the major speculative attack on Asia, but before the attack on Brazil and Argentina. -Ed

Brazil can breathe more easily. The reason why: American economist Paul Krugman thinks that this country is in a much better situation than the Asian Tigers. "The immediate risk of a financial crisis seems remote to me", told Exame the MIT economist, who in March was getting ready for a series of conferences in Brazil. Believe it, for the financial markets, that opinion is a thousand times more relevant than detailed explanations by [Brazilian Finance] Minister Malan about the [Brazilian currency] real's good health. If Krugman's conclusion had been in the opposite direction, the government's economists would have serious reasons to lose sleep.

Krugman is today perhaps the most acclaimed economist in the world. His opinion is respected both by his academic colleagues and by market operators. Specialized in financial crises, he saw his fame take off when he predicted, a few years ago, that Asia's rate of economic growth could not be sustained for long. When that region's markets collapsed, at the end of last year, a prophet myth was created. Krugman says that it wasn't quite like that. "Although I was expecting problems, nobody could imagine that something of that magnitude would happen". Never mind. The point is that his opinion is worth gold (a conference can cost up to 70,000 dollars). Regarded as brilliant by his peers, in 1991 he won the John Bates Clark award, the American version of the Nobel Prize. It is awarded every two years to an economist younger than 40. Speaking of the Nobel Prize, Krugman is a sure bet as a future winner due to his contributions to international trade theory. "I'm not worried about that yet", he says. "Ask me again in ten years' time".

Krugman received Exame for about two hours in his office in the MIT, Boston. His room, stacked with books and papers, is next door to the offices of two Nobel Prize winners, Robert Solow and Paul Samuelson. The main parts of the interview follow:

Exame – Do you think that Brazil is under the risk of a speculative attack?

Paul Krugman – No. The Asian financial crisis worked as a sort of immunization for Brazil. The government rightly became frightened with what happened and is taking actions that it under other circumstances would not have taken: it has cut the budget, acted towards austerity and raised interest rates to defend the currency. One year ago I was much more worried about Brazil than I am today. The current-account deficit isn't too large and can be financed. The short-term external debt is high, but nothing like what we saw in Asia. When the debt is compared to the foreign reserves, the picture that comes up isn't too bad.

But aren't there similarities between Brazil and those Asian countries?

Brazil's problem is different. The banks seem to be much healthier than in Asia, since there was no credit boom. But you have the twin deficits, fiscal and external. What should worry Brazil isn't a crisis like the one in Asia, where the main problem was bad loans by banks. In Brazil the risk of a crisis concerns economic fundamentals. The danger is that the budget deficit gets out of control and the government decides to finance it by printing money. In that case the speculators, anticipating problems, would attack the currency. The government would regard as unacceptable the political cost of inflating interest rates and would opt for devaluating the currency instead. That's what might have happened. But I don't believe in that scenario anymore. The Brazilian government has already proved that it will do whatever it takes to defend the real.

There is a certain consensus in Brazil that the currency is overvalued. What is the ideal moment to correct that?

If you look at the domestic and foreign balances, you realize that the Brazilian economy is decelerating. Under normal circumstances, you could consider adopting expansionary monetary measures. The necessary side effect is a currency depreciation. But one thing is certain: now is not the time to devalue the exchange rate. Not with such unstable financial markets. In my view, the main contagion of the Asian crisis in Brazil is psychological: the financial market today associates devaluation with lack of control and catastrophe. Because of that, Brazil must wait until everything settles down. There's a funny side: if the mark falls, there will be no sign of panic in Germany. But all the countries that are lumped together with the Asians have to be very careful in the present moment. Unfortunately, that's still the case of Brazil.

Countries such as Brazil that have just stabilized their currencies have an overvalued exchange rate. Is that the only way to defeat inflation?

It is possible to argue that. Those countries look for something dramatic to mark the end of inflation, and to use the exchange rate is certainly one of the best ways of doing that. But since inflation does not disappear instantly, the result is a severe overvaluation. That's the case of Brazil, Argentina and Mexico, among others. The problem is to solve the overvaluation without provoking a crisis. The truth is that to this day nobody has managed this transition very well. Many countries remained stuck to the fixed exchange rate, like Argentina.

But Brazil has a much more flexible regime.

In principle yes, but nobody dares to change the exchange rate. It is true that there isn't a convertibility law that would say that 1 real equals 1 dollar. You will have to keep the current policy for a while. I imagine that by the middle of next year we will have a climate in which rational macroeconomic policies can be considered. Now the speculative gods demand sacrifice. All you must do is not allow the hot money to cause more disasters.

Do you prefer fixed or floating exchange rates?

There are many theories about that. A small and open country such as Monaco, for instance, must fear a flexible rate. On the other hand, it would be madness if the US decided to fix the dollar to the euro. Between those two extremes you find all sorts of things. As far as the Mercosur [South American common market] countries are concerned, I think that there are no reasons for maintaining a fixed rate with the dollar in the long term. Brazil's trade with Europe and Asia is very intense. Therefore, it makes no sense to fix the exchange rate with the dollar. Besides, the whole region remains an exporter of commodities, subject to strong oscillations. A good example is Australia. They have a floating regime and are quite satisfied. In the long term I think the Brazilians would have done better if they had managed to make the transition to the same regime.

Brazil is criticized for maintaining a high current account deficit. Is there something wrong with that policy?

Let's continue with my example. Since 1980 Australia has had an average deficit of 4.2% of GDP without any problem. If it weren't for the political and economic uncertainties of emerging countries, there would be no problem to finance a deficit of that size. Brazil's current account deficit is reasonable. If it reaches 8 or 10% of GDP (like Mexico in 1994 or Malaysia in 1996), then we'll have something to think about.

Now, some months after the Asian crisis, can we understand what happened in those countries?

I think that there are two basic streams of explanation: mine and Professor Jeffrey Sachs's. Sachs explains the crisis with the concept of a financial panic. According to this version, some unknown event is capable of detonating a confidence crisis in healthy economies. Investors decide to withdraw their money and their pessimism fulfills itself. In the end, the crisis ruins an economy that had no serious problems. My own evaluation does not contradict that view. But I believe that there's more to it: the so-called moral hazard, what I call the minister's nephew problem. The nephew borrows some money and the bank thinks that's always safe. Too risky loans are the result. Sooner or later the excess of investments becomes unsustainable. Think of a 80-store building, well built, on top of which another twenty are erected using very poor material. If they collapse, they'll probably bring the whole building down.

Your interpretation seems to suggest a gloomier future.

I think that Sachs and I agree that it's a financial crisis, not one due to more real factors. If the financial problem is solved, growth can resume. If you believe Sachs's version, the panic will vanish as quickly as it started. But if you believe in the existence of the moral hazard there is much more to be done. Even so, there is a great possibility that growth resumes in two or three years. I don't think that that was the end of the Asian economies. The financial crisis in Chile in 1981 was remarkably similar. The good news is that Chile recovered and returned to an economic miracle. The bad news is that the initial effect was catastrophic: a slump of 15% of GDP.

Do you think that Japan will get out of its crisis?

The Japanese economy remains trapped. They, too, have serious problems with banks. But I don't believe that they are vulnerable to a financial crisis. The Japanese have huge reserves and no foreign debt. But can they get the economy moving again? For that they would have to act much more radically. What I suggest is a monetary policy as expansionary as possible, something that hasn't been tried yet. As simple as that: to print money. As if loaded helicopters would dump money on the cities. Japan today resembles the developed countries in 1937: a deflationary economy where not even near-zero interest rates can channel savings towards investments. Being responsible, in this case, is the worst they could do. Unfortunately, their economy is so wealthy that they still don't feel pressured to act.

What about China?

China is a mess. The banking system is even worse than in elsewhere in Asia. And they have all the difficulties of an still incomplete economic reform. Just like Japan, I don't think China will face a financial crisis, if only because its currency is non-convertible. That means that, if there is a run to the banks, people will withdraw yuans, which the government can print. Besides, they don't have a very large short-term foreign debt. But I think that in the medium term China's economic growth will be of 4%, much lower than the present 10% a year.

Is there a risk of devaluation of the Chinese currency?

Not in the short term. No emerging economy can even consider that. Maybe they will devalue in one year or two, but only if everything is calmer.

And South Korea?

They will have a very bad year. Unemployment will increase and there will be more strikes. But I think that, as far as the finances are concerned, a strong reaction has begun. The Koreans managed to renegotiate their short-term debt and to put the immediate financial crisis under control. Now they have a current account surplus and private investment is returning.

Inflation is going up in Asia. Could it neutralize the devaluation of that region's currencies?

I don't think that there will be anything like a complete nullification of the devaluation in real terms, as in Brazil in the 80's. The devaluations in Asia will be much higher than inflation. That will make those countries more competitive. As a matter of fact, exports are increasing already. There is a problem in the statistics: with the crisis, trade within Asia declined, but exports outside the region are growing. Inflation is not what's worrying, but the recession and collapse of credit. After the crisis the banks aren't managing to provide credit for exporters. If they solve that problem, they will become much more competitive.

Do you believe in a second round of devaluation in those countries?

I think that the real exchange rates will remain at the present levels for quite some time. It's possible that some currency still moves a bit, but nothing like what's happened.

What are the main lessons of the crisis?

There are many. It showed that the countries affected have serious problems. The crisis was selective. Taiwan, for instance, does not have a bad banking sector and did not suffer much. Hong Kong was hurt, but not ruined. Latin American countries suffered attacks but did not succumb. Another important lesson is that such crises are happening over and over again. This was the second big financial crisis of the 90's. An explanation is the existence of global financial markets, without a global financial authority – a combination that starts to appear very dangerous. Previously, there were national financial markets, limited to national capital and controlled by monetary authorities. The banks faced no competition, were very profitable and inefficient. But they were also very safe. With the global financial market, banks started to take perhaps excessive risks. Previously, a financial crisis could be controlled by the central banks. But who can do that today? True, there is the IMF. It just happens that it has neither financial nor political capital to face this new situation. Some innovation is necessary.

Is a new Bretton Woods necessary?

Yes, but not in the old sense of a world of fixed exchange rates. What we really need is a super-IMF. A IMF capable of quickly lending 250 billion dollars and, eventually, losing 15 billion of those. If the IMF had been able to provide an unlimited amount of money to Asia, knowing that a large part would go down the drain to cover loans made to presidents' relatives, the crisis would have been contained.

With such a super-IMF wouldn't banks be free to lend even more money to the minister's nephew?

Yes, you're right. Let's go further, then. Why does the US Fed work so well? In part, because it has an unlimited amount of money. In part, because it possesses much regulatory power and information on banks. It knows exactly which are solvent and which aren't. It would be good to count on a similar institution in the global system. Somebody is needed who is capable of meddling in the daily affairs of countries that are going to receive money.

Which will Brazil's role be in world trade?

Transportation costs are plummeting and communications are always getting better. That allows the productive chain to be divided in smaller parts, which opens opportunities for manufacturing and sophisticated services in developing countries. But you shouldn't expect that to happen very quickly. The great doubt is whether there will be a turning point in trade liberalization. The long-term trend is towards an ever larger world trade, with more exports of manufactured products from developing countries. But there is always the possibility of delays and setbacks in that trend.

How do you see the idea that world trade is a war in which a country wins and another loses?

You mean the zero-sum game. I think that those who say that simply haven't understood trade theory. The concept that there can be mutual gains from trade between countries is extremely complex, and there are those who don't accept it. Besides, many simply don't care for the market, and the international market has everything those people don't like. Actually the big question should be the distribution of benefits within countries, not between them.

Does international trade benefit the whole world?

Not every single person in the world, but it is very difficult to think of one country that does not profit from international trade. Free trade is very good for the workers of the Third World, who benefit the most. It's also very good for people like myself, the high-skilled professionals of the developed world. It isn't that good for the lower-skill workers of the developed world and for the traditional landlords and capitalists of the developing world. In human terms, the benefits from trade are immense.

What do you think of the suggestion that the world might be producing an excess of goods?

An excess in relation to what? To man's desires? Surely not. To purchasing power? But production generates income and, therefore, purchasing power. The concept of an excess of capacity makes no sense at all.

You have become a star since the Asian crisis. Has that changed your life?

I'm not very famous here in the US, and so my life hasn't changed much. One thing that has changed is that now I spend a lot of time in airplanes and more time talking than thinking. It's very difficult to resist those changes. When someone asks me to go to some country to explain my view of how the world works – and, besides, paying me a lot of money – it's very difficult to say no.

Once you attributed capitalism's success to selfishness.

Well, we aren't living in a very favorable time for idealists. We're almost at the end of the millennium, and in this century we tried everything. What's left is a system hopelessly dependent on selfishness. I'd rather believe that it would be possible to have a better option. But in real life many dreams become nightmares.