Feature: The Global Financial Crisis

WHAT IT MEANS TO BE AMERICANS

            An MSU economist explains what caused the current global financial crisis, how it will affect Americans, and which solutions offer the best hope. 

            Early in 1998 the world became painfully aware of an emerging global financial crisis. It began in Asia and spread to other parts of the world, having impacted the United States as well. In particular, the crisis began in mid-1997 in five Southeast Asian countries: South Korea, Thailand, Malaysia, the Philippines and Indonesia. South Korea, the most advanced of the group, has been admitted to the OECD group of industrial countries. The others belong to a trading block (ASEAN) that aspires to form a free trade area.

            Least developed are Indonesia and the Philippines. Indonesia, the fifth largest country in the world with 200 million people spread over many islands, suffered from extreme corruption and nepotism during the regime of President Suharto. Its crisis runs deepest--a depression coupled with 75 percent inflation. 

            For three decades these economies grew at a rate of 6-10 percent per year--the highest growth rate in the world. They were dubbed the 'Asian Tigers,' and their performance was enshrined as 'the Asian Miracle.' They also weathered the debt crisis of the 1980s, which profoundly affected Latin America. By contrast their growth rate turned negative to the tune of 5-7 percent in 1998 (in Indonesia, the decline of real GDP exceeded 13 percent), signaling a deep recession, rising unemployment, and a sharp rise in poverty. In the case of Mexico, one year after the collapse of the peso in December 1994 the economy was growing strongly. 

            In contrast, the afflicted Asian economies remained in a recession a year later. Adjectives like the Asian 'meltdown,' 'catastrophe,' and 'cyclone' became common, as did the popular phrase, 'From Asian miracle to Asian debacle.' This Southeast Asia crisis is unique in several respects. No one accurately foresaw it. It had no recent precedent in terms of cause, depth, and duration. The prospects of immediate return to high economic growth are not good. Intensifying the crisis is the stagnancy of the Japanese economy, the regional giant. Japan faces its own crisis, where many banks are burdened by bad loans of up to half a trillion dollars. The amount equals the U.S. Savings and Loans debacle of the 1980s for an economy that is only one-third the size of the U.S. 

            By August, the yen had depreciated 30 percent to an exchange rate of 140 yens to one dollar. Economic growth ceased while unemployment grew. In July, Japan elected as prime minister Mr. Obuchi, who promised to stimulate growth by cutting taxes and/or increasing public spending. While Japan has enough reserves to withstand a 'currency crisis' (the speculative withdrawal of funds from the country) and is experiencing a large and growing trade surplus, the fact that it is a significant market for Asian exports and a major source of regional investments and loans, makes its stagnation a major problem for Southeast Asia. 

            What afflicts the Asian Tigers is not just a recession in the real economy. Many observers believe that the root cause of the problem lies in the financial sector. Stock markets and other assets, including real estate, plummeted by up to 40 percent as did the exchange rates--the most important asset in an open economy. Most Southeast Asian currencies, pegged to the dollar at a fixed rate, were forced to 'float' and subsequently depreciate. Causes of the Asian Crisis At the root of the crisis is an age-old problem: Full currency convertibility (including in particular that of the capital account) fixed or targeted exchange rates and independent monetary policy cannot coexist. When they collide--a crisis results. 

            This was at the root of many postwar currency crises, including the 1992 crisis in Europe. This latter episode was triggered when Germany, for domestic reasons, raised the interest rate. Because exchange rates were fixed within the European Community and capital movements within Europe were set free, Germany's move attracted a flood of capital from the rest of Europe. The U.K., Italy, Spain and other countries could not withstand the withdrawal of funds and were forced to re-impose currency controls or to abandon fixed exchange rates.

            In the same manner, the Asian crisis erupted following the removal of restrictions on the inflow and outflow of capital in the five countries. Indeed, countries like China or India, which retain capital-account controls, were not affected directly (indirectly, however, their exports to the afflicted countries declined). This led some leading economists to reconsider their position that emerging countries should abolish control on the capital account of their international transactions as soon as possible--at least this step should not be taken prematurely.

            The five afflicted countries also maintained a fixed (or targeted) exchange rate--pegged mainly to the U.S. dollar--and each pursued independent monetary policies. But the clash between the three objectives in the Asian case ran deeper than in earlier episodes in other countries. If that is so, then it is because the proximate causes that overlay the fixed exchange rates and free capital mobility, were of serious magnitude. 

            While there is no consensus on the complete list of causes, most observers include the following: Large inflows of short-term portfolio capital that could be quickly withdrawn. The five afflicted countries sustained a net 'swing' of $105 billion--from an inflow of $93 billion in 1996 to an outflow of $12 billion in 1997. Sizeable current account deficits, financed in large measure by short-term capital inflows. Very high ratios of short-term foreign liabilities to international reserves (up to 210 percent in Korea). In other words, unlike Japan, foreign reserves were not sufficient to withstand massive withdrawal of capital. 

            A relatively high proportion (14 to 19 percent) of non-performing loans to total outstanding loans of the banks; namely, a domestic banking crisis was also at the root of the problem. It destroyed confidence in the economy and made it impossible for banks to provide adequate credit even to reputable firms and sound consumers; credit being the lubricant needed in a market economy. 

            The burst of a 'bubble economy.' 

            Much capital, domestic and foreign, had been invested in the stock markets and real estate markets of the five countries, lifting asset values sky high. When domestic banks began to curtail and even call back loans, and foreign investors began to withdraw their capital, these overpriced markets collapsed, causing a substantial reduction in people's wealth. Within a year, stock markets in the afflicted countries fell by up to 40 percent. In some cases, overvalued (fixed) exchange rates contributed to the crisis. 

            In addition, a 'contagion' effect took hold as the crisis spread from one economy to another. It began in Thailand, on July 2, 1997. Large withdrawals of capital forced the authorities to float the baht, which depreciated quickly. In August 1997, Indonesia floated the rupiah, and within months the crisis spread to the other countries. Some observers attribute this to a 'herd instinct' of investors, coupled with expectations. As the Thai market caved in, financiers expected countries with similar circumstances to fall as well, and then started withdrawing their capital, causing their expectations to be realized. 

            This was contagion through financial markets: Once confidence in one country is undermined, investors lose confidence in, and remove their capital from, other similar 'emerging markets.'