When Medicine-Men Failed

THIS January at Davos, I heard a startling confession by Stanley Fischer, macro-economist and first deputy managing director of the International Monetary Fund. Over a drink, Fischer admitted that many of the traditional macro-economic indices of health had failed to reveal the magnitude of the crisis in East Asia. In particular, the IMF didn't get an early grip on the extent to which the rot had spread in banks, financial institutions and capital markets of South Korea and Indonesia. Fischer also acknowledged that understanding the micro-economics of banking, corporate governance and capital markets was critical, but admitted that the Fund didn't have in-house expertise to deal with such issues. The global emperor of macro-economics had no clothes.

There is little doubt that Indonesia and South Korea exposed the poverty of traditional macro-economics. In 1995-96, none of the indicators showed any deep-rooted malaise. Both countries were enjoying high growth rates in national and per capita income. Neither had fiscal deficits worth the name. Korea's current account deficit was well within safety limits; and while Indonesia's was a bit high at 3.5 per cent of national income, it was more than adequately covered by net inflow of foreign capital. Inflation was in single digits. True, Indonesia had a large external debt liability, but its exports were more than thrice the annual debt-servicing burden. At the end of 1996, hardly any macro-economist claimed that Indonesia and Korea were going to be in trouble.

So, why did the macro-economists fail? I'm convinced that the fault lies in forgetting a book that was published in February 1936—John Maynard Keynes' The General Theory of Employment, Interest and Money. To my mind, Keynes' greatest contribution was his understanding of investors' expectations, and how these could affect the real sectors of the economy via capital markets. That's not surprising, for Keynes was a brilliant stock and bond market player. His systematic forays raised his personal net worth and that of King's College, Cambridge, and gave him an unparalleled understanding of expectations. He wrote in Chapter 12: "The Stock Exchange revalues many investments every day (which) give a frequent opportunity to the individual to revise his commitments. It is as though a farmer, having tapped his barometer after breakfast, could decide to remove his capital from the farming business between 10 and 11 in the morning and reconsider whether he should return to it later in the week."

Those sentences were written in the era of Douglas Fairbanks, telephone operators, cigarette holders and manual typewriters. Today, three clicks of a mouse in New York can instantly move huge volumes of shares or bonds in Tokyo, or substitute the won and the yen for the D-mark. Keynes could have hardly dreamt of the speed with which today's investor expectations and capital markets can affect the real sector. It is this instantaneous nature of cyberspace transactions that makes the financial sector, capital markets and expectations central to sensible macro-economics.

Since the advent of floating exchange rates in the late 1970s, instances of bearish expectations affecting vast herds of investors have been few and far between. The Latin American crisis of the 1980s could be contained by a big US-sponsored bailout; and the Mexican crisis of 1994 corrected itself by the end of 1995. By and large, the trading world was pretty predictable, and traditional macro-economists could prosper using their old diagnostic tools. Once in a while, a country would get into a balance of payments problem and approach the IMF. The Fund doctors would prescribe minor variations of the same medicine. So long as the infection was localised, the remedy worked.

This has been ripped apart by East Asia. Never since the Great Depression (1930-34) has the globe seen as large and as powerful a trading region get hammered like this. The infection started in May 1997 with Thailand, which the IMF had predicted quite early. It immediately spread to Malaysia and Indonesia. After a respite, it erupted in October, hitting Indonesia, Hong Kong and Korea. Hong Kong resisted, but Korea went under. Then another respite before round three further affected Korea and Indonesia, and finally Japan. Round four was directed at Korea, Japan and Malaysia. By this time Indonesia was kayoed. The archipelago has had food riots, and there are dangerous prospects of widespread political and ethnic violence. As yet, there is no guarantee that Korea's charred banks and financial institutions will be able to rise from the ashes to finance the kind of production and exports that are needed to lift the country out of negative growth. Thailand remains on the edge. Round five looks like moving to Brazil.

It's in the context of regional slide that the MIT professor Paul Krugman has suggested slamming temporary controls on foreign exchange transactions. His argument flows from another quote of Keynes, this one from his 1919 classic, Economic Consequences of the Peace: "There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."

Krugman's suggestion is simple and potentially dangerous. The IMF cure isn't working. Most of East Asia has slipped into debilitating recession. One can't use fiscal deficits, easy credit and loose money to stimulate demand under full exchange rate convertibility. That will risk immediate depreciation of the currency and another round of crisis. So, do the daring alternative. Impose exchange controls as a temporary measure to get the economy out of recession, and then return to full convertibility. Almost on cue, Malaysian premier Mahathir Mohammed has adopted the Krugman formula. From September 30, international transactions with the ringgit will be severely restricted.

The problem with exchange controls is that it is more dangerous than most other controls. As we know well in India, granting forex permits becomes a lucrative business; crony capitalism thrives; bureaucrats and politicians fatten themselves in unimaginable ways; and there is a huge temptation to maintain such controls long after their useful life. It is too early to say whether Malaysia's version of Krugman will deliver the goods. But, if you were an East Asian politico who saw everything crumble without traditional economists giving a solution worth the name, you too might clutch at a Krugman straw. The wily old doctor from Malaysia might just pull it off. Who knows?