Learning the Wrong Lessons from the Asian Financial Crisis: Martin Wolf Glosses Nouriel Roubini

Martin Wolf in the FT glosses Nouriel Roubini, but ends this episode with a cliff hanger:

FT.com / Columnists / Martin Wolf - What Asians learnt from their financial crisis: The Asian financial crisis of 10 years ago taught two contrasting lessons: the one the majority of western economists thought the Asians should learn; and the one Asians did learn. The western economists concluded that emerging economies should adopt flexible exchange rates and modern, well-regulated and competitive financial markets. The Asians decided to choose competitive exchange rates, export-led growth and huge accumulations of foreign currency reserves. The question is whether the Asians need to change their choice. The answer, I believe, is “yes”.

When downward pressure on the Thai baht started 10 years ago, nobody expected what followed – its devaluation in early July. That seemingly small event generated a financial tsunami that engulfed most of east Asia and overwhelmed Indonesia, Malaysia, the Philippines, South Korea and Thailand. Exchange rates collapsed, financial systems went bankrupt, governments teetered on the edge of default and economies succumbed to deep recessions....

With the important, but geographically limited, exceptions of Argentina and Turkey in 2001, the crises of 1997-98 have so far been the last in the long series of financial crises that afflicted emerging economies in the 1980s and 1990s. Today, the desire of outside investors to put their money in these economies is overwhelming, as is shown in the strength of their financial markets, the low spreads on external borrowing and the size of the private capital inflow.... The IMF is now almost entirely out of business.

What explains this new stability? As Nouriel Roubini of New York University’s Stern School of Business argues, the Asians did not learn the lessons most western economists thought they should.... [T]he great mistake, Asian policymakers concluded, was not pegged, but overvalued, exchange rates. That error was what had brought the humiliating dictation by IMF officials operating under the thumb of the US Treasury. “Never again” became the watchword. Never again has been the result. Now the east Asian emerging economies are mostly creditor nations. Moreover, much of their accumulation of external assets is in official hands (see chart). By February of this year, the foreign currency reserves of east and south Asian countries had reached $3,280bn....

The scale of the reserve accumulation demonstrates the obvious: these countries have refused to adopt the freely floating exchange rates many outside economists recommended. They have, instead, chosen to keep their exchange rates down. This, in turn, has generated current account surpluses. Sustaining such surpluses requires a stable excess of savings over domestic investment. One instrument they have used has been sterilisation of the monetary consequences of reserve accumulations, to prevent the normal expansion of money and credit, overheating, inflation and so loss of external competitiveness.

If a substantial part of the world economy is generating huge current account surpluses, somebody else has to run offsetting deficits.... It is no accident then that the US has emerged as the world’s chief deficit country – its “borrower of last resort”. It alone is able to be a vast net borrower without risking the health of its financial system.... Mr Roubini argues that... [this] policy generates ultimately unsterilisable increases in foreign currency reserves. This causes excess monetary growth, domestic asset price bubbles, overheating, inflation and the loss in competitiveness that governments had tried to prevent by suppressing the rises in nominal exchange rates. It distorts domestic financial systems, by pushing interest rates below equilibrium levels. It generates a waste of resources in accumulation of low-yielding foreign currency assets exposed to the likelihood of huge capital losses. It makes Asian economies excessively dependent on demand from outside the region. It exacerbates US protectionism. Finally, it compels US monetary authorities to sustain easy monetary policy, in order to offset the leakage from domestic demand caused by the huge current account deficits.

The post-crisis policy system has proved more durable than many (including myself) expected. At its heart, however, is China. Though not affected directly by the crisis, it was one of the countries that learnt its lessons in the Asian way. Today’s result is a dynamic behemoth accumulating foreign currency reserves at a rate of $50bn a month in the first quarter of the year and expected by the IMF to generate a current account surplus of 10 per cent of gross domestic product this year. I do not believe these astonishing trends are desirable or sustainable. Why that is so and what to do about it I intend to discuss next week...

Comments

[Doctor Jay]

The primary holder of foreign (mostly US Treasury) assets in China is the Chinese government, right? They accumulate and hold these assets in order to keep their exchange rate favorable. The primary risk to them is that the assets devalue because of inflation in the USD.

Could it be that they simply don't care about this? They are determined to "eat bitter" in order to ride the wave as long as they can?

And furthermore, doesn't that suggest that maybe that the path of unwinding this is, in fact, inflation in the USD?

[Bruce Wilder]

These articles always feature China -- the "behemoth" amongst the others, Thailand, Korea, etc.

Why doesn't Japan get more prominent mention?

Isn't the Bank of Japan, a bigger "behomoth" in purchasing U.S. dollar reserves than China?

And, Japan doesn't even have the excuse of being a developing country.

[Bupa]

Martin often ends with cliff hangers because he is limited to a confined space once a week and so has to spread his thoughts over several weeks.

Roubini is calling for Martin Wolf for World Bank president. It sticks with the Wolf theme of Wolfensohn and Wolfowitz and rewards the FT for helping to bring down the latter.

Suspicious though that Roubini posts for Martin Wolf on Monday and on Tuesday Martin Wolf highlights Roubini's paper.

[andres]

Wolf may be right from the pure economic theory point of view, but the Asian countries show that they understand the actual rules of the game and its policy implications much more than Wolf does.

China's and other countries practices with regard to their exchange rate may be partly to blame for the current global imbalances, but if or when the crunch time comes and the US has difficulty servicing its debt obligations it won't be the Asian nations wich are called upon to adjust by the IMF--it is going to be the US Treasury and the Fed which which will have to learn the conditionality language of Stand By Arrangements or other IMF "facilities". Either that or China and the Asian countries will rightly withdraw from the IMF.

In a world in which IMF aid is conditioned only on adjustment (read: austerity) by the borrower country, it pays to run current account surpluses as a matter of habit, and I'm surprised that Wolf doesn't seem to understand that.

[andres]

Oops, I almost forgot to mention that the above is based on the assumption that the Fed doesn't decide to artificially default by inflating away US debt. In that case, they won't need to turn to the IMF, though the Fed presidents and governors will then require a massive bodyguard escort in order to keep from being lynched by an angry population.

[Matthew Saroff]

I agree. Wolf is ivory tower on this and wrong.

It's not about economics, it's about the abilities of those societies to choose their own path, and having to go back to the IMF every few years when another wave of speculation hits, would prevent that.

Remember, Malaysia told the economists and IMF to pound sand, and they did better than everyone else.

[Barry]

andres, they could probably get away with it. *If the powers-that-be decided that an episode of inflation was their best bet*.

If not, it wouldn't be the angry public that'd threatan the fed officials; it'd be the large holders of those financial instruments which would suffer from inflation. Bodyguards wouldn't help there (heck, Wall St would just bribe the bodyguards to do the hit themselves).

And in an extremity, those financial holder might agree to inflation, as long as they are bailed out.

[wkwillis]

Um, is it Wall St., or is it Wall St.'s customers, that are net long on US dollars?

[David]

Doctor Jay,

You wrote "And furthermore, doesn't that suggest that maybe that the path of unwinding this is, in fact, inflation in the USD?"

Yes, I believe so. If there is a lot of inflation in the USD, that could lead to a devaluation of the USD, which could set off a chain reaction of competitive devaluations, like what we saw in the 1930s.

Then again, the future is hard to predict.

[Robert Waldmann]

What's the problem ? Roubini describes two problems 1) "It distorts domestic financial systems, by pushing interest rates below equilibrium levels." and two
"It generates a waste of resources in accumulation of low-yielding foreign currency assets. " the second being an inevitable consequence of "current account surpluses. Sustaining such surpluses requires a stable excess of savings over domestic investment. "

The complaints seem to be that these countries are investing too much ("interest rates below ..." and "asset price bubbles...") and that they are investing too little (wasting savings on accumulation of ...). Well which is it ? What good would higher interest rates and lower asset prices do them ? One long term risk is a "decline in competativeness" that is ending up where Roubini says they should be right now.

Seems to me that they are doing fine (counting the huge capital losses they will have when the dollar finally tanks).

The only distortion is that they are not consuming enough, but it's not like people are starving. East and South East Asians have never consumed so much before. The fact that they are going to consume much much more in the not so distant future means that their savings behavior is not optimal, but we should all make such mistakes.

Brad (who has checked his e-mail) will notice that I actually take the model illustrating the advantages of irrationality semi seriously.

OK how about the USA. US residents are consuming too much and will not be able to count on capitalist excess financed subsidies from the Chicoms forever. The USA will be less rich in the future than it would be if everyone obeyed instructions from academic economists. So what ? The USA is absurdly rich now and is getting richer, albeit more slowly than economists think it should. Any risk that the financial crisis to come will cause (edven more) severe poverty in the USA can be eliminated by taxing the rich and expanding the EITC yes the EITC hurray for the EITC.

[Doctor Jay]

Well, here's why I think its may be a problem for us. We are starting to see a brain drain.

Tech jobs are moving out of the country. They aren't yet the really key ones, the plum ones. But maybe that's just a matter of time. I would very much not like to see my industry, the electronics/computer industry become part of the military-industrial complex, like the aerospace industry has.

I won't say its a done deal. The science/engineering culture in India and China isn't yet to the point where they will win Nobel prizes with regularity. I give India the edge in this race, because of a less authoritarian culture.

[fab]

Hey Brad--

Did you really work with Kindleberger?

Tell us some stories about the great man. He was my wife's favorite economist, back when she was writing her thesis on the IMF.

(sorry to put this here, but comments are not enabled in the post quoting Doug Henwood on Summers & Volker, where you mention Kindleberger.)

[Barkley Rosser]

This is a comment on the post from Henwood, since none were openly allowed for it, at lest not on my computer, although it relates to this thread also. Two points.

1) The real problem for Kindleberger was economic management at the beginning of the Great Depression, very much echoed by the newer consensus coming out of people such as Barry Eichengreen. So, the real issue was that the US was effectively the new hegemon, but had not realized it/did not wish to accept the "responsibility" to play the role. So, as the US economy began to sink after the stock market crash (actually had begun downwards a tad earlier a bit), tight monetary policy was maintained to keep gold flowing into the US, as if the US was some rinky dink player at the world level. This, of course, was the main trigger for contractionary policies in other countries to offset this, combined, of course with the outbreak of a global trade war following the also very narrow-minded Smoot-Hawley Tariff Act of 1930.

2) Regarding today, the new hegemon is clearly China already, and unlike the US in the late 1920s/early 1930s, it is propping things up by continuing to take all those dollars. Clearly it is losing money doing so, but it continues to do so, mostly for its own reasons, although it may have learned the lesson of history and is aware that if it lets things unwind, well, we would get into a situation that would give serious pause to a lot more people than just Paul Volcker and Larry Summers.

[Darrell]

American’s cannot generate the income needed to fund their ongoing expenses: the Iraq war, the maintenance of its infrastructure: roads, schools, etc, and an ongoing list of expenses that are needed to keep its industry, its government, and it consumption lifestyle going. American’s annual ongoing expenses are greater that it’s annual ongoing income.

Currently our excess expenses are being funded by foreign central banks, by foreign institutions, and by foreign investors.

This occurs because the dollar is recognized as legal tender by most foreign central banks; as such, foreign institutions and foreign merchants accept the dollar in exchange for their goods and services. They in turn convert their dollars into their national currency and reinvest the currency into their own economy. And this is why China’s economy has a high growth rate.

Because the dollar is accepted as legal tender through out the world, American has an unlimited expense account. Our income does not govern how much goods and services we can purchase rather our expenses are govern by how much currency our government will issue in order to obtain the goods and services needed to fuel the economy.

For several reasons central banks never got together to develop rules that govern the use of national currencies as globalized legal tender:
1. The globalize economy came onto the world scene so quickly and things happen in a haphazard manner, that no central governing body was organized to regulate the processes;

2. The finance systems used to fund the cold war era economy was transferred to the globalized era economy, and the world central banks accepted these systems rather than impede the globalize process by developing new finance system to govern world commerce.

America’s unlimited expense account has fueled economic growth through out the world, but expenses cannot exceed income forever.

It’s for the historian’s to say what effect this mal-distribution of resources has had on the world economy, but it is for present day economist to say how the globalized finance system should be reorganized so that this mal-distribution can be corrected and future systems will function equitability and fairly in the globalize world economy.