NY Times. What's an Ailing Economy to Do?
September 10, 1998
ECONOMIC SCENE
By MICHAEL M. WEINSTEIN
he International Monetary Fund, having bailed out Thailand,
Indonesia, South Korea and Russia over the last 15 months, is
nearly out of money, and Congress is not yet rushing to its defense.
But its job is far from complete.
The financial crisis that it tried to snuff out in Asia has spread to Latin
America and beyond. Investors are still dumping won, pesos and
rubles in a grab for dwindling reserves of dollars, driving up the costs
of imports for consumers and depriving economies of desperately
needed foreign capital.
With the IMF partly sidelined for now, the debate on how to stop the
financial carnage rages at two levels -- what beleaguered countries
should do for themselves and what the international community should
do for them. One important step the industrialized powers could take
-- debt relief -- has worked in the past. But otherwise, the outlines of
a solution remain murky as economists find that many of the old
panaceas do not work.
The best way to insulate an economy from investor flight is to cut
excessive borrowing. But as Argentina, Mexico and other Latin
American countries are learning, responsible monetary and fiscal
policies are no sure-fire inoculation. Their problems are primarily
external, starting with a steep drop in Asian demand for oil and other
exports that has siphoned off dollars and scared away skittish
investors.
Beyond balancing its books, a country must decide how to link its
economy to the outside world. A fixed exchange rate sets the value of
a currency in terms of the dollar, providing day-to-day stability for
exporters and investors.
Some conservatives, like Jack Kemp, the Republican vice presidential
candidate in 1996, preach fixed rates in part because such a regime
requires a government to protect the value of its currency by
maintaining a strict monetary policy.
The ultimate fixed-rate regime is a currency board -- a policy rarely
mentioned before the crisis in Asia -- by which a country restricts the
issue of its currency to the amount of foreign reserves it accumulates.
Argentina prints a peso only when it acquires, through export sales or
capital inflows, an additional American dollar. Its currency board
thereby assures investors that Argentina holds enough dollars to
redeem pesos whenever they decide to cash in their investments.
By linking a currency to the dollar, a currency board in effect transfers
control over a nation's money supply to Washington. It is a reflection
of desperate times that some respected economists, like Rudiger
Dornbush of the Massachusetts Institute of Technology, have
embraced the idea of a currency board for Russia. What would have
seemed like an unthinkable infringement of a superpower's
sovereignty a year ago now seems like Russia's possible salvation.
But fixed-rate systems bottle up tremendous economic forces that
eventually spew forth with potentially cataclysmic consequences.
Consider Hong Kong. As its Asian trading partners collapsed, its
exports plummeted, cutting deeply into its dollar reserves. The
shriveling reserves have raised doubts about Hong Kong's ability to
maintain the value of its currency by putting up as many American
dollars as it takes to soak up as much of its currency that investors
might want to sell.
That leaves Hong Kong -- like Russia, Brazil, Venezuela and other
countries defending their exchange rates -- facing unappetizing
options: abandoning its currency peg -- almost certainly exposing itself
to huge devaluations -- or luring dollars by raising domestic interest
rates to levels that risk curbing economic growth.
The danger, as the Nobel laureate Milton Friedman warned more
than 30 years ago, is that fixed exchange rates provide only an illusion
of stability. Rate changes are infrequent, but when they do come, they
can hit with the force of a bomb. Floating rates, which he says are
preferable, are adjusted continuously in response to internal and
external shocks, diminishing the danger of a calamitous day of
reckoning.
Another decision that each country must make is how open it wishes
to be to foreign capital. Here again, the intellectual climate is changing.
Most economists have preached the gospel of open borders in the
belief that capital would migrate to its best use and that competition
from abroad would keep domestic entrepreneurs honest.
But recent events in Asia and Latin America -- where the whims of
currency traders and short-term investors have tormented seemingly
healthy economies -- have led many economists to embrace another
erstwhile heresy: capital controls, by which governments control
buying and selling of foreign currency.
Jagdish Bhagwati of Columbia University, one of the world's foremost
advocates of free trade, now encourages countries to consider
adopting controls during financial crises. Paul Krugman of MIT
endorsed controls earlier this month, which, at least in his mind,
influenced Malaysia's decision last week to follow his advice.
Controls are intended to enable a country to loosen its monetary and
fiscal policies when it needs to in order to fight off recession without
fear of setting off a massive flight of dollars, which can no longer be
taken out of the country upon demand. But Jeffrey Sachs of the
Harvard Institute for International Development warns countries to
limit their use to inflows of short-term investment. If, instead, countries
try to block investors from taking their money out at will, controls may
wind up driving foreign investors away for good.
Running parallel to the debate over domestic policies is a battle over
the role of the IMF. It has assumed responsibility -- in Mexico in
1995, Asia in 1997 and Russia in 1998 -- for bailing out countries in
financial distress, lending tens of billions of dollars in exchange for
commitments by those countries to tighten fiscal, monetary, banking
and employment policies.
In the case of Mexico, intervention worked well. In other cases, as in
Asia and Russia, IMF policies have backfired, at least in the view of
critics. Sachs accuses the IMF of cracking down too hard in Asia,
needlessly fueling investor panic.
C. Fred Bergsten, director of the Institute for International Economics
in Washington, concedes that the IMF made serious errors as the
Asia crisis unfolded, though he says that it has largely corrected its
significant miscues since then.
Contradicting many of the IMF's critics in Congress, Bergsten argues
that the world needs a well-financed institution that can lend money to
countries in temporary distress, preventing one country's ills from
needlessly infecting others. He does, however, call on the fund to
better monitor countries before a crisis hits and to intervene earlier.
Sachs would switch the fund's mission from organizing grandiose
bailout packages to organizing negotiations between debtor nations
and their creditors. His idea is modeled on the U.S. bankruptcy
system, which allows judges to put creditors on hold while a
settlement is reached. Sachs recognizes that the fund would need a
similarly powerful legal lever if it were to play a similar role.
The latest remedy gaining fashion would have the central banks of the
United States, Germany and Japan jointly announce a cut in interest
rates beyond what Japan announced on its own Wednesday. The
idea is to harness the cooperative spirit that, by some accounts,
helped solve the problem of a soaring dollar in the 1980s and use it to
break the pessimistic mood of international investors. Joint rate cuts
would also provide relief to economies with large dollar-denominated
debts.
But while the symbolism of joint international action might turn
investors into optimists, it is easy to exaggerate the likely effect of a
joint rate cut. Interest rates in the industrialized West are already low,
and the United States is loath to drive them much lower because its
economy is, at least for now, growing briskly. Besides, rate cuts do
nothing to cure serious ills, like Japan's insolvent banks or Russia's
corrupt institutions.
But Alan Blinder, an economics professor at Princeton University and
a former vice chairman of the Federal Reserve, provides a clever
political rationale for a joint rate cut.
If it were combined with an ironclad commitment by Japan to solve its
banking problems -- a necessary step to its recovery and therefore
Asia's -- the joint rate cut would rise above symbolism. Still, Blinder
describes the case for joint rate cuts as borderline.
There is, however, one effective remedy on which most economists
agree. Russia and other besieged countries cannot pay off their
Western loans. Just as debt relief was the key to South America's
recovery in the 1980s, debt relief will have to be part of any solution
to the current plight of Russia and Asia. The sooner it comes, the
sooner a widespread economic rebound can begin.
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