Global Policy Forum

By David Felix

Journal of Commerce
July 9, 1998 (David Felix is professor of economics, emeritus, at Washington University in St. Louis.
This article was distributed by Bridge News.)

Media pundits and their mentors from Wall Street and Washington blast Japan for not reducing savings, increasing its fiscal deficit and bailing out its banks. But they are focusing on Act III of the ongoing Asian drama while conveniently ignoring the opening scenes.

In Act I, early on in the crisis, the International Monetary Fund and Washington rejected Japan's proposal for a revolving $100 billion Asian Monetary Fund to stabilize East Asian exchange rates against the speculative attacks then under way.
In Act II, the IMF took full control of the crisis management and transformed a confinable crisis into a catastrophe of global reach.
Now in Act III, Washington and the IMF desperately pressure Japan to adopt ultra-Keynesian expansionary measures to contain the catastrophe.
It remains to be seen what Acts IV and beyond will bring.

Japan proposed the $100 billion monetary fund in August 1997. Japan, China, Taiwan, Hong Kong and Singapore were to contribute most of the $100 billion, and the weaker East Asians the rest. All the designated countries quickly signed on.

Because the East Asian currencies were not yet in free fall, it is likely that the monetary fund would have deterred the currency runs. This would have allowed the countries time to reform their banking systems, to moderate the cost in output and employment and to reallocate production toward exports and import substitutes. We'll never know for sure, however, because fierce opposition from the IMF and the United States -- contending that the Asian fund would be too lenient -- forced Japan to withdraw the proposal.

The IMF, which had been urging the Asians to decontrol their financial markets while issuing glowing evaluations of their economic progress, explained the currency runs as the financial market's way of disciplining Asia for gross mismanagement of its economies. It offered credits totaling some $130 billion to the hardest hit of the countries, contingent on their carrying out an IMF program designed to regain the confidence of the financial markets and reverse the capital outflows. This program required the governments to guarantee the foreign debts of local banks and corporations, avoid capital or import controls and instead stabilize the exchange rate by monetary-fiscal tightening.

Protected from default, foreign creditor banks hung tough on rolling over their short-term Asian loans. This exacerbated the hard-currency squeeze on local debtors, causing them to rush to buy foreign exchange to cover their increased dollar needs. The exchange rates went into a free fall despite the IMF credits.

To halt the fall, central banks, as required, tightened domestic credit. Interest rates skyrocketed, setting off a wave of loan defaults, bankruptcies, plant closures and layoffs. Bad loans, collapsing asset prices and exploding hard-currency liabilities rendered most of the banking systems insolvent. Shrinking tax revenues and the rising cost of servicing government debt thwarted efforts to reduce fiscal deficits. Depreciating exchange rates and skyrocketing interest rates pushed up the price level, depressing real wages.

Despite the falling wages and a depreciating exchange rate, a systemic credit crunch denied surviving firms the short-term credit they needed to expand production for export. Faced with disintegrating economies and rising social tensions, the IMF began to offer its credits on more lenient terms, which provided marginal relief, but failed to reassure the financial markets.

Act II ended with the flight of financial capital to Eastern Europe as well as Latin America, and with market hotshots pleading in unison for a massive new injection of bailout funds from the IMF and the Group of Seven industrialized nations.

The catastrophic IMF programs violated the theoretical premise underpinning the IMF-Washington faith in the value of financial-market disciplining. This is the premise that financial markets are efficient, in that they correctly assess expected returns and risks in pricing assets. If true, this would mean that the terms on which the foreign creditors had lent to the Asian private sector prior to the crisis already incorporated an adequate risk premium to cover default and other lending risks.

In requiring Asian governments also to guarantee full payment of private foreign debts and to squeeze their economies in order to make good the guaranties, the IMF was converting the risk premiums into riskless extra payoffs to foreign creditors at additional cost to the debtor economies.

The efficiency premise has, however, neither theoretical nor empirical support. Indeed, the Bretton Woods Articles of Agreement, still the IMF's charter, were designed on the alternative premise that the attainment of free trade, stable exchange rates and full employment requires restricting the international mobility of financial capital. The designers of Bretton Woods arrived at that premise after observing the disastrous experience with destabilizing financial flows between the two World Wars. The IMF has been egregiously violating Article 6 of its charter, which authorizes the use of capital controls, and Washington has been supporting that violation. Both need to act on the Bretton Woods premise to avoid plunging the world economy into a full repeat of the interwar experience.