What sank Asia? Money sloshing around the world

By Robert Kuttner, Business Week, 27 July 1998

We are learning once again the fundamental difference between free commerce in ordinary goods and free commerce in money. The former is broadly efficient—it subjects business to bracing competition and allows products to find markets anywhere in the world. The latter is destabilizing and deflationary—it holds the real economy hostage to the whims of financial speculation, which is vulnerable to herd instincts, manias, and panics. In ordinary commerce, prices adjust and markets equilibrate. In global money markets, erratic and damaging overshooting is the norm.

Exhibit A is, of course, the Asian crisis. The Asian collapse is widely blamed on structural problems—too much state interference in economies, crony capitalism, and thinly capitalized banks. But that system, while in need of overhaul, did produce exceptional growth for two decades. The more important cause of the Asian crisis is the sudden exposure of these nations to the speculative whims of unregulated financial capital. It is impossible to run an efficient economy when your currency swings by 100% in just a few months.

EASY TARGETS

The fundamentals of most Asian economies remain enviable—high savings rates, well-educated and disciplined workforces, high rates of productivity growth. However, when these economies became targets for global financial speculation, they were abruptly exposed to forces beyond their control. Hot money poured in, seeking supernormal returns. When the hot money resulted in overbuilding followed by falling expectations, the money poured out just as quickly. To reassure the same global speculative capital, these nations, encouraged by the International Monetary Fund, resorted to tight money and deep economic contraction. The kowtowing to skittish financial markets has led to generalized deflation.

In popular memory, John Maynard Keynes is (wrongly) associated with simple deficit spending. But at the heart of the Keynesian insight about the failure of markets to self-regulate is the disjuncture between the real economy of long time horizons with fixed obligations and the short-term, often irrational character of financial markets.

The Bretton Woods system was an attempt to square this circle. Bretton Woods married free commerce in goods to regulated commerce in money. It created fixed exchange rates and controls on private capital movements—precisely so that free trade in goods could coexist with high growth and full employment. Financial speculators had no role in the Bretton Woods system, so there was no systemic bias in favor of slow growth.

Bretton Woods collapsed, however, because it was never anchored by the global credit system envisioned by Keynes. Rather it was temporarily anchored by the U.S. dollar. But when the need to finance expanding global commerce collided with the need to maintain domestic price stability, dollar hegemony became too great a stretch. The U.S. sacrificed fixed exchange rates, finally ending the Bretton Woods system in 1973. It is more than a coincidence that 1973 also began the era of slower growth.

SAFETY NET

With the collapse of Bretton Woods, a new generation of free-market fundamentalists insisted that money was just another commodity with prices set by markets like the price of ordinary goods. Exchange rates should float; all capital markets should be totally permeable. Recent events, however, have proven this view tragically wrong.

If we are not careful, the world will enter a deflationary spiral not unlike the Great Depression, triggered by events in Asia. The American architects of Asian rescue can’t decide whether they trust speculative markets to govern flows of currency and capital. On the one hand, the Clinton Treasury backs the IMF view—liberalize capital markets, get government out of the way, reassure investors. On the other hand, Treasury Secretary Robert Rubin talks of the need for Asian social safety nets; he encourages Tokyo to bail out its banks and urges the Chinese to keep pegged exchange rates—none of which policies exactly reflect deference to market forces. The policy muddle reflects an intellectual muddle.

Ad hoc damage control coupled with self-defeating austerity is the wrong approach. Better to act systemically, with a Tobin Tax on short-term currency transactions, as well as a more managed system of capital flows and exchange rates. It remains to be seen whether today’s statesmen can rise to the occasion or whether they are still prisoners, as Keynes once put it, of the ideas of defunct economists.