Wednesday, March 3, 2010
This is a guest contribution by Marshall Auerback, Braintruster at the New Deal 2.0
By Marshall Auerback
My colleague, Rebecca Wilder, recently concluded a "Tale of Two Recoveries: Malaysia vs Germany" which brought back memories of my own time in the Far East and some of the advisory work I did for the government of Malaysia during the financial crisis of 1997/98.
Before the historical revisionists get hold of this period, it is important to note that Malaysia’s initial response to the crisis was a textbook illustration of how to exacerbate, not alleviate, a financial crisis. Of course, it was a consequence of taking stupid and economically ruinous advice from the International Monetary Fund, which is to economic development what John Meriwether is to asset management. If anybody had any doubts, those of us who observed the crisis first hand realized that the IMF and the so-called “Committee to Save the World” were more interested in saving the first-world banks who were exposed than caring about the local citizens who were scorched by harsh austerity programs. Same old, same old.
It was only when the Deputy PM/Finance Minister was ousted from the Cabinet and his pro-IMF policies completely repudiated, that Malaysia’s economy began its long road back to successful recovery.
There is little question that former PM Mahathir Mohammed was a political thug, but not an economic illiterate. But his sacking of Anwar from the Cabinet and decision to press ludicrous sodomy and abuse of power charges against his former heir apparent foolishly undermined his economic legacy. It is certainly wrong, however, to criticise his response to the Asian financial crisis of 1997/98. Vindicated now with the benefit of hindsight, at the time his embrace of exchange controls, and a 180-degree reversal away from the policies of austerity advocated by the Fund, were viewed as dangerously anti-free market, destined to render Malaysia an investment pariah.
Before the temporary triumph of the so-called “Washington consensus” school of economics in the late 1990s, the so-called “interventionist” East Asian alliance model of capitalism was highly lauded by institutions such as the World Bank and even the IMF itself. A common thread characterizing the economic development of countries such as Thailand, Korea, Singapore, and, yes, Malaysia, were policies which transferred resources away from “unproductive” toward “productive” uses—often in the form of transfers from unproductive groups to productive groups and sometimes in the form of policies to convert unproductive groups into productive ones. Creating “rents” (above normal market returns) by “distorting” markets through industrial policies was essential, first, to induce more-than-free-market investment in activities that the government deemed important for the economy’s transformation, and second, to sustain a political coalition in support of these policies. Disciplining rent-seeking so that it remained consistent with these two objectives was also essential.
It was precisely this model that came under such sustained attack during the late 1990s. Then Secretary of the Treasury Robert Rubin, his Deputy, Lawrence Summers, and their lieutenants saw the crisis as the perfect opportunity to destroy this model once and for all, and to do this, they wanted the International Monetary Fund to impose conditions on the economies of emerging Asia that went far beyond the Fund’s traditional boundaries. Thus the U.S. Treasury kept steady pressure on Fund officials to extract more and more concessions from South Korea, Thailand, Indonesia, and Malaysia including instant resolution of all trade related issues in favor of the United States. The exasperated Asians were soon accusing the IMF of always raising new issues at the behest of the United States—something that the Fund officials readily acknowledged later.
Foremost in the minds of Treasury officials was also the interest of Wall Street, especially American financial services firms. These biases were manifested in the types of IMF conditions imposed on the emerging Asian economies during the height of the crisis, which clearly served the brokerage firms on Wall Street far better than the needs of emerging Asia.
In the early 1990s the economies at the core of the world economy (the U.S., “Euroland,” Japan), began to generate hugely excessive liquidity. In the early 1990s, mutual funds, pension funds, other institutional investors, hedge funds and—last but not least—banks became awash with deposits. They scoured the world for high returns. Investment houses like Goldman Sachs and Morgan Stanley sought the business of arranging the privatizations, securities placements, mergers, and acquisitions that surged on the wave of liquidity—business that became their main growth area. As a consequence, financial capital poured in to “emerging markets” (middle-income countries of recent interest to institutional investors).
Capital flows to developing nations in Asia and Latin America jumped from about $50bn a year before the end of the Cold War to about $300bn a year by the mid-1990s. From 1992-96, Indonesia, Malaysia, Thailand, and the Philippines were all experiencing money and credit growth rates of between 25-30 per cent a year. Emerging market stock markets boomed, nearly doubling their share of world capitalization between 1990 and 1993.
Proponents of capital liberalization justified these inflows on the grounds of (a) maximizing the efficiency of capital worldwide, (b) allowing a specific country to invest more than could be financed from its own savings, (c) bringing modern financial institutions into the country, and (d) deepening the liquidity of the country’s financial system and lengthening investor horizons, thereby making markets more efficient and more stable. In the end the case for free capital flows came down to the classic theory of comparative advantage, as though trade in dollars was essentially similar to trade in widgets.
In reality, however, the funds went into increasingly marginal and speculative developments and simply exacerbated an underlying credit bubble. Although they did not speak out at the time, a number of prominent economists and financiers have since pointed out the dangers of such “gypsy capital”. Joseph Stiglitz, for example, argued that the origins of the Asian financial crisis rested, in the first place, with the excessively rapid financial and capital market liberalization that the U.S. Treasury had pushed on these economies, on behalf of Wall Street, and over the protests of the Council of Economic Advisors, of which he was the chairman. “At the Council of Economic Advisors we weren’t convinced that South Korean liberalization was a matter of U.S. national interest, though obviously it would help the special interests of Wall Street” (Globalization and Its Discontents, New York: W. W. Norton, 2002, p. 102).
Similarly, Jagdish Bhagwati, one of free trade’s most passionate supporters for developing nations, argued that the idea of free trade had been “hijacked by the proponents of capital mobility”.
The end result of this drive to liberalise capital accounts in immature emerging economies was a series of booms and busts, culminating in financial crisis. Capital flows into emerging markets turn out to be less a diversification of assets, more another instance of “investment herding”, especially within regions, where market allocation was propelled less by differences between countries in their “fundamentals” (including “good” or “bad” policy) than by “push factors”—macro push factors like the amount of excess liquidity in different parts of the core zone of the world economy; and micro push factors like the incentives on institutional money managers and the corresponding drive to match the “benchmark weightings” devised by pension fund consultants, many of knew nothing of the various underlying markets. Money managers tend to be evaluated relative to the median performance of money managers in the same asset class. This encourages them to move in and out of markets together, producing “herding” or “trend chasing” or “positive feedback trading” and the crisis of 1997/98 was a textbook illustration of that phenomenon.
Malaysia was heading down this road in 1997. The currency, the ringgit, was collapsing, as the contagion effects from Thailand, Korea and Indonesia gradually extended into the country. Although Anwar had not placed the country under a formal imf program, he had been following the imf recipe: to forestall capital flight, fiscal policy was tightened and interest rates were hiked in order to protect the external value of the currency.
Based largely on their experience in Latin America, the Fund had already imposed directly these measures on Thailand, Indonesia, and Korea. The problem, however, is that whereas fiscal deficits have tended to be large and inflation chronic in Latin America, in the economies of emerging Asia, budgets had long been roughly in balance. In addition, as the Funds’ economists were unschooled in the links between macro conditions and corporate balance sheets, they failed to perceive the danger of high real interest rates in economies with high debt/equity ratios and low inflationary expectations. High real interest rates have deflationary and crisis-signalling consequences that prompt capital outflows regardless of the attractions of the high rates themselves.
Which is precisely what began to occur in Malaysia. The Malaysian economy experienced a contraction of credit growth from 30 percent in 1997 to minus 5 percent in 1998, reflecting a massive pullback of bank loans. The ringgit plunged, as capital outflows accelerated. A real estate collapse loomed.
Ultimately, seeing the failure in these policies, Prime Minister Mahathir sacked Anwar, and re-imposed capital controls to insulate his economy from the deleterious consequences of rapid hot money outflows. (The trumped-up political charges, which led to the latter’s imprisonment, only came later.) Monetary and fiscal policy became expansionary, the ringgit was pegged to the US dollar, and crisis credit conditions began to diminish as domestic rates were reduced drastically. Although Western finance ministries and institutional investors protested apocalyptically and predicted that Malaysia would remain beyond the pale of the investment world for the foreseeable future, six months later even The Economist, one of the IMF’s great apologists, was forced to acknowledge that the embrace of capital controls had done “short-term wonders” in assisting recovery.
This is all old history. But it is worthwhile recalling the actions of the Fund in the context of what it is advising countries like Iceland and Latvia to do today. Or when considering the hair shirt economics which seems to be championed by Germany’s economic elites.