An Explanation of the Asian Financial Crisis
January 5, 2000
The Story of Rapid Economic Development Through Globalization
The leaders of nations have a choice of whether to join in the world economy. Consider a country that has, for a long time, been isolated from it. Suppose that its leaders decide to open their markets sufficiently to join the world economy. Such an country would, at first, grow very fast. This rapid growth would help to conceal various anti-market regulations, high taxes, inflationary spending, special privilege and even corruption by the leaders and others in the economy. However, the "growth curve" must ultimately level off. If the country has open financial markets, this leveling off is likely to be accompanied by a stock market crash, a currency crunch, a depressed property market, and a recession.
The Quantity Theory of Money
The reasoning for this can be expressed by means of the old quantity theory of money with a modern twist on expectations. Prices in the hypothetical country that fits my description are based on expectations. So long as the country is expanding at a given rate, the government can engage in inflationary spending (spending that is greater than taxes and borrowings) at a given rate and the banks can issue additional credit money without causing any problems that would be observable to the newly wealthy citizens. But when the rate of growth levels off, unless the rate of increase in the money supply is also cut back, the result will be "too much money chasing too few goods." An economist who followed the quantity theory of money would regard this as a recipe for inflation.
The Austrian Theory of the Trade Cycle
But there is a twist which can best be expressed by means of the Austrian theory of the trade cycle. This theory is based on the assumption that the new money enters via loan markets through the market interest rates. If this happens, the market rates of interest will be temporarily depressed below their long-term "natural rates." Not realizing this, individuals and businesses will use this essentially "easy money" situation to expand their long-range planning. They will borrow heavily and make large capital investments, the payoff of which will not be forthcoming for many years. A good example is a housing and corresponding property boom.
The people, at first, do not realize that the (real) interest rates are artificially low because of their failure to account for the changed ratio of money to goods. Eventually, however, they catch on. The first to do so are likely to be the financial speculators. These need not be foreign; typically they are domestic banks. As soon as they begin to suspect their error, they will raise the market rates of interest, perhaps even higher than the long-term "natural rates." This will render many of the long term projects obsolete, since the businesspeople who started them are unwilling to complete them at the unexpectedly higher interest rate. As they layoff workers, a recession ensues. The recession will continue until households and businesses come closer to adjusting their expectations to reality.
Of course, not only businesses and households make mistakes. Governments also carry out long term spending projects. They also must realize their errors and cut back. This is often not easy to do, since the government budget is a source of income for government leaders. In a democracy, a generous budget helps to keep the leaders in power by giving them an advantage in elections.
Can Intervention in Financial Markets Help?
Intervention in the markets will not normally help matters. Indeed, some types of intervention -- like banning currency speculation -- will make matters worse; since it is only through changes in money values that the markets can adjust. The businesses and households need to know that the long-term projects were mistakes under the conditions that now prevail. These projects must be replaced by projects with shorter time horizons. If businesses and households cannot learn this through markets, they will not be able to learn it at all.
International Bailouts and Constraints
Under these conditions, consider an international agency, like the International Monetary Fund (IMF), which agrees to bail out the government, subject to the conditions that it must put into place fiscal, monetary, and property rights reforms that facilitate the functioning of markets and pricing. If the agency enforces these conditions, it will be doing the people a favor. (Actually it is not the international agency that is granting the favor but the taxpayers who support the agency.) On the other hand, if the agency does not enforce its demands and simply props up an unwise and spendthrift government; it will prolong the pain.
An Old Lesson
I have stated this principle as if it applies only to countries that are "catching up" in the world economy. However, it applies more or less equally to the countries to which others are trying to catch up. If these countries begin to follow loose money policies, as many Western economies did during the sixties, they will ultimately face the same painful market adjustments if they want to regain their "competitiveness."
Are Foreign Speculators to Blame?
Here's some advice for people who blame their domestic problems on foreign speculators, the IMF, the World Bank, the global economy, and so on. It is that if domestic fiscal and monetary policies operate to conceal a country's true growth and financial situation, the culprit is really your own government. If other countries compel your government, in its own best interest, to correct this situation; you should be grateful. On the other hand, if other countries merely prop up your government while allowing it to continue in its destructive policies, you should be gravely disappointed, no matter how much your leaders try to blame their woes on foreigners.
J. Patrick Gunning
Professor of Economics/ College of Business
Feng Chia University
100 Wenhwa Rd, Taichung
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