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East Asia's Economic Revenge

In a matter of a few short weeks during the summer of 1997, the thriving countries of east Asia saw their economies overwhelmed by a financial tsunami. First Thailand and Indonesia, and then South Korea and Malaysia, saw investors panic and watched capital flee. Their currencies plummeted in value and their biggest companies wrestled with bankruptcy.

After being held up as models of successful development, these countries were suddenly denounced by the International Monetary Fund and prominent economists everywhere for their lack of transparency, poor accounting standards and crony capitalism. The IMF came into the region with a rescue plan that imposed harsh conditions. It demanded that these countries impose austerity plans and allow foreign investors to buy up their businesses at depressed stock prices.

The other part of the story was that the IMF insisted that these countries repay their debts. The only way they could do so was to export like crazy. This route was opened to the Asian countries by the plunge in the value of their currencies, most significantly against the dollar. The result was that goods from the region became very cheap to American consumers, yielding a flood of imports to the United States.

There was a second route that the IMF could have followed for debt repayment. In recognition of the severity and extraordinary nature of the crisis, the IMF could have allowed for substantial write-downs of debt by the countries of the region. But it chose not to follow this route.

Of course the IMF was not an independent actor. The organisation takes its lead from the United States. At the time, the folks calling the shots were the trio that Time magazine dubbed the "Committee to save the World" (CSW): Alan Greenspan, Robert Rubin and Larry Summers.

The IMF "rescue" for east Asia had important ramifications for the rest of the developing world. The message that developing countries took away from the IMF's east Asia rescue was that they never wanted to be in a situation in which they were forced to turn to the IMF for help. The one way that they could prevent being forced to turn to the IMF was to accumulate massive amounts of foreign reserves as a defence. The only way to accumulate foreign reserves is to run a balance of trade surplus.

This effort by developing countries to accumulate reserves meant that it was not only the countries of east Asia who were exporting like crazy, but rather the whole developing world. Reversing the conventional view in economic theory, in the years after 1997 there was a massive flow of capital from the developing world to the wealthy countries, with the United States being the biggest recipient.

This capital flow from the developing world created the hothouse in which the US housing bubble could flourish. The jobs lost to imports created weakness in the labour market. Even though the 2001 recession officially ended in November of that year, the economy continued to shed jobs for nearly two more years, in part due to the loss of jobs to imports. Seeing this weakness in the labour market, the Federal Reserve continually pushed interest rates lower, reaching 1% in the summer of 2003.

Low interest rates in turn sustained the bubble far longer than otherwise would have been possible. The bubble itself helped to conceal many of the excesses and outright fraud perpetuated during these years. In a world where housing prices are rising by more than 10% a year, and generating enormous profits for the firms in the real estate and banking sector, many sins can be concealed.

But bubbles inevitably burst. The bursting of the housing bubble will erase $8tn in wealth (more, if prices overshoot) and will leave many of the country's pre-eminent financial institutions bankrupt. More important, it is throwing the US economy into its worst downturn since the Great Depression.

In history, we never get second chances, but it is still worth asking the question of what the world would look like if the CSW had taken the other path. Suppose Greenspan, Rubin and Summers had instead arranged for the IMF to write down a large portion of the east Asian debt so that they were not forced to place the same priority on exports.

Furthermore, a less onerous rescue would not have created the same rush to accumulate reserves across the developing world, as did the bail-out designed by the CSW. We can't know exactly how things might have turned out if the CSW had taken this alternative path, but it's likely that Rubin's shares in Citigroup would be worth considerably more money today.

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