Reflections on the Asian Financial Crisis

What is now known as the Asian Financial Crisis began in July 1997 in Thailand where the baht fell victim to massive speculative attacks. Before the currency was finally devaluated to lose over half of its value, the country’s economic growth came to a grinding halt amid disastrous layoffs in previously booming sectors as finance and real estate. The Thai stock market lost so much as 75 percent of its value within mere months.

With Thailand’s economy apparently so similar to that of other newly industrialized East Asian states, investors worried that others would soon follow in its downfall so they began to pull out. The contagion that spread was deeply interwoven with the fact that many of Asia’s emerging economies had their currencies pegged to the American dollar. Businesses in these countries in the preceding years had borrowed massively in dollars. When their native currencies were devaluated, loans suddenly had to be repaid in more expensive dollars. Investors feared that many of the loans could not be repaid at all so they called in short-term loans or refused to renew them. By the time the states had depleted their foreign exchange reserves in desperate attempts to defend their currencies; East Asia was already abandoned by investors who had fled in widespread panic. The expectation of devaluation had made devaluation inevitable. The previously so blossoming young economies of East Asia were now thrown into a state of despair with many businesses collapsed and millions unemployed, once again living in poverty.

In the wake of the crisis, an intellectual debate quickly erupted over its origins. The “Asian Miracle” of previous years had so impressed many commentators that it was difficult to understand how it could have apparently collapsed within such short time.

Different economists have proposed that a rapid liberalization of markets and privatization of enterprise left the fast growing East Asian economies vulnerable to the sort of financial speculation that preceded their contagion. Others have argued instead that the turmoil was due to the very involvement of the state in the economic sphere.

The “political regime type” of the different East Asian economies that were engulfed in the crisis of the late 1990s as well the structure of the relations between business and government in these countries were extensively examined by economist Stephan Haggard, “Governance and growth: Lessons from the Asian economic crisis,” published in Asian-Pacific Economic Literature 13, 2 (1999). The topics are interrelated and together may explain for the institutional weaknesses which plagued the affected economies.

Institutions, in Haggard’s analysis, refer to the “formal and informal rules and enforcement mechanisms that influence the behaviour of organisations and individuals in society.” As such, they include laws and norms, both written and unwritten, as well as all agencies operating in the public sphere, including, but not necessarily limited to, bureaucracies, political parties, unions, pressure groups and NGOs. Haggard’s is the premise of Douglass North’s who has argued convincingly in the past that the institutional framework of a society is of major influence upon its economic growth and development. “Institutions,”according to North, “Institutions,” Journal of Economic Perspectives 5, 1 (1991), “are the humanly devised constraints that structure political, economic and social interaction. They consist of both informal constraints,” such as customs and traditions, “and formal rules,” as laws. “Together with the standard constraints of economics they define the choice set and therefore determine transaction and production costs and hence the profitability and feasibility of engaging in economic activity.”

From an institutional perspective, it becomes possible to shed some light on the obvious differences in both symptoms of and reactions to the crisis between different Asian states. According to Jeffrey Henderson, “Uneven crisis: institutional foundations of East Asian economic turmoil,” Economy and Society 28, 3 (1997), in Thailand, Malaysia and Indonesia, “panic took hold when banks, other financial institutions and property development companies began to collapse.” Nearly all of them had been financially overexposed as a result of their lending policies. In Korea, on the other hand, “the symptoms took a very different form.” The problem there lay with the gargantuan business conglomerates known as the chaebol which had massively overborrowed from both domestic and foreign banks. According to Henderson, these differences were no coincidence, rather “a direct consequence of the structural evolution of the respective political economies.”

Once panic took hold of the entire region, further differences along similar lines were exposed. According to Haggard, “The particularly poor performance of Indonesia during the Asian financial crisis and the ability of Thailand and particularly Korea to adjust with some alacrity” seemed to indicate a weakness on the part of the more authoritarian governments when it came to adjusting readily to a crisis. Previous arguments in favor of state capitalism — “the capacity of the government to reconcile, or over-ride, particular interests in the name of overall social welfare; and the ability of the government to adopt a longer time horizon, unconstrained by elections, short-term political pressure, or the myopia of the electorate” — may appear effectively undermined in this regard. Haggard nuances this view slightly by pointing out that much depends on the authoritarian leadership in question while democracies aren’t always as prone to shortsightedness as the aforementioned analysis would suggest. Indeed, “there is probably no significant relationship between economic performance and regime type on way or the other,” is Haggard’s conclusion.

More importantly, probably, is the relation between state and economics or, in the case of most East Asian countries, just how government and business were intertwined. Robert Wade, in “The Asian debt-and-development crisis of 1997-?: Causes and Consequences,” World Development 26, 8 (1998), is quick to dismiss the notion, promulgated by the likes of Alan Greenspan, at the time still chairman of the American Federal Reserve, Steve Hanke, economist and Forbes magazine contributor, and Stanley Fischer, then first deputy managing director with the International Monetary Fund, who blamed the supposed “death throes of Asian state capitalism” for the crisis. In this view, excessive state interventionism promoted “investment excesses and errors,” in the words of Greenspan, speaking before the New York Economics Club in December 1997. “Government-directed production, financed with directed bank loans, cannot readily adjust to the continuously changing patterns of market demand for domestically consumed goods or exports.” Testifying before Congress on January 30, 1998, Greenspan was all the more explicit, noting that “domestic savings and rapidly increasing capital inflows [that] had been directed by governments into investments that banks were required to finance” lacked a true market test were largely unprofitable. “So long as growth was vigorous, the adverse consequences of this type of nonmarket allocation of resources were masked” and sustained, as Fischer also stressed, by pegged exchange rates and lax supervision. The expectation that the exchange rates would last at least for the duration of a loan, if not indefinitely, contributed to a surge in funds which, “together with distortions caused by government planning,” led to huge losses when the inevitable slowdown occurred. The state of confidence “so necessary to the functioning of any economy” according to Greenspan, was torn asunder in the face of rapid retrenchment.

This narrative, with its emphasis on the fallacies of pegged currencies and economic planning, was, according to Wade, blithely adopted by the IMF to inspire its actions when it was called in to restore the affected Asian economies to stability. He doesn’t reject Greenspan’s more general analysis that government is inherently incapable of directing economic activity but does deny that government involvement was to blame in this instance. Instead, he favors more regulation.

In his assessment, Wade eventually deranges with his criticism of the IMF into something of a conspiracy theory that sees major American and British financial forms working in conjunction with a lethal mix of IMF, the World Trade Organization, even the Organization for Economic Co-operation and Development — in short, the Washington Consensus — to thrust the poor Asian economies in a globalizing market place and force them to abandon traditional power and capital structures in favor of cold and rational Western models. No matter the hopes of the aforementioned free marketers that the crisis would compel Asia to dismantle entirely its failed attempt at state capitalism, “far from representing the triumph of global neoliberalism,” the crisis, he predicted, “may be looked back on as the beginning of its end.” We are still hearing such warnings today.

Wondering whether there is any truth to the argument that “crony capitalism” contributed to the downfall — with corruption, arbitrary government favors or outright nepotism creating moral hazards and an inefficient allocation of capital and resources — Haggard notes that in the case of industry at least, the allegation doesn’t hold up. In both Malaysia and Korea, industrial central planning had been dismantled by the late 1980s while in Thailand nor Indonesia, industrial policy played much of a role in the crisis — though government involvement in Indonesian industry was both profound and distorting. In the case of banking, government involvement in Korea “may have sent misleading signals to the private sector,” yet the country was distinctive among those affected by the crisis in allowing a number of large commercial firms to fail.

Cronyism and corruption did have distinctly negative effects however in that they undermined rational investments and caused uncertainty about government action and the sanctity of property rights. That, notes Haggard, “contributed to the undermining of confidence.” This was the case in Korea, Indonesia, Thailand and Malaysia where the “lines between government, party and private roles” were particularly blurred. A classic moral hazard took shape as “politically connected individuals or institutions,” in the words of Paul Krugman, speaking at Credit Suisse First Boston, Hong Kong in March 1998, “were widely perceived to be backed by implicit government guarantees.”

Haggard is reluctant to blame corruption outright — “which implies illegal activities” — but attests that the “political responsiveness to business interests” certainly bordered on it in many of the affected countries. “A combination of a high level of discretion coupled with relatively weak regulatory agencies permitted policies which, even if not technically corrupt, created both classic economic distortions and a high degree of uncertainty over the government’s policy stance.”

In the final analysis, there is no denying that international flows of credit and capital, which helped the economies of East Asia prosper in times of growth but fled rapidly in times of panic, contributed significantly to the dip that followed devaluation. Had the governments of the affected countries restricted short-term financing from abroad and met their met their short-term financing needs from domestic sources, the mere devaluation of their currencies “would not have trapped them in a liquidity crisis that soon turned into a solvency crisis,” in the words of Garett Jones, “‘The free market’ and the Asian crisis,” Critical Review 14, 1 (2000).

The very high levels of short-term, private-sector debt that led to the crisis would not have existed in such magnitude if it weren’t for government or quasigovernment interventionism however.