Must-read. Mercury. Free-market philosophy loses its luster
mercurycenter.com
Published Sunday, September 6, 1998, in the San Jose Mercury News
'The free market has failed disastrously,' Malaysia's Prime
Minister Mahathir Mohamad declared.
BY ROBERT A. RANKIN
Mercury News Washington Bureau
WASHINGTON -- As nations from Asia to Latin America
tumble farther into economic chaos, some are turning in
desperation to a remedy that financial authorities from Wall Street
to Washington have long considered poisonous to global
prosperity -- curbing free markets.
This growing trend may represent a historic turn away from the
post-Cold War global consensus that has prevailed through the
1990s -- that U.S.-style free-market economic systems provide
the surest route to national wealth.
Even many leading free-market champions in the United States
now say that state controls on one kind of market -- the trading
across borders of currency -- may make good sense, at least as a
short-term remedy, for many troubled nations.
''The free market has failed disastrously,'' Malaysia's Prime
Minister Mahathir Mohamad declared last week as he announced
that his recession-wracked country is shutting down free trade of
its currency, the ringgit.
Russia took a similar though less sweeping step last month when it
announced it will not pay some foreign debt on schedule, and
political pressure is growing in Moscow to halt all
foreign-exchange trading of the ruble. Venezuela and other Latin
American nations are weighing similar controls.
''I think what's going to come out of this is different strokes for
different folks,'' said Barry Bosworth, a former top economist
under President Carter now with the Brookings Institution.
''What we are finding is that we all are in different stages of
financial-market development, and the same rules are not
appropriate for all.''
Such anti-market moves abroad could even benefit the United
States by restoring stability to the roiling global marketplace,
many experts say, even though such steps flatly contradict the
free-market orthodoxy preached on Wall Street and at the U.S.
Treasury Department and the International Monetary Fund.
Their Establishment gospel maintains that underdeveloped
economies will get the investment capital they need to modernize
only if foreign investors' money is allowed to flow in and out of
markets freely.
But the goal of imposing currency controls is to free national
economies from the dominance of foreign investors so that
domestic interest rates can fall and spur home-grown economic
revival.
Many Asian nations -- led by Thailand, Indonesia and South
Korea -- have been driven into punishing recessions over the past
year largely because they raised interest rates sky-high in an effort
to keep foreign investors' money flowing in. The high rates
crushed their economies.
To be sure, each now-troubled nation benefited enormously over
the past decade from massive inflows of foreign investment, which
fueled rapid economic growth and rising living standards. But in
the process, businesses and banks in those countries ran up
massive debts owed in dollars and other ''hard'' foreign
currencies, such as German marks.
Unless each country maintained a stable exchange rate for
converting its currency into dollars, those debts would grow more
onerous. However, financial speculators, led by enormously
wealthy Wall Street ''hedge funds,'' began selling those currencies
''short,'' betting that would drive the currencies' price down in
global markets.
The speculators were gambling that the governments did not have
enough hard-currency reserves to buy back their own currencies
and maintain their value. The speculators stood to earn billions
from currency trading if they prevailed, and often they did, at the
cost of disrupting the economies of their target nations.
Potential for disruption
''As the IMF estimates that hedge funds and bank proprietary
trading departments control close to $100 billion of assets, there
is little doubt that they have the potential to disrupt the financial
markets of small and medium-sized countries if they concentrate
their firepower on them,'' noted David Hale, chief economist of
Zurich Insurance Group, in a recent newsletter to clients. ''In
1997, for example, one hedge fund had a short position in the
Thai baht equal to about 20 percent of the country's foreign
exchange reserves.''
Speculators were not the only cause of Asia's spreading
economic crisis, of course. Each of the affected countries had
serious economic problems rooted in ''crony capitalism'' and
weak banking systems.
But such weaknesses did not deter investors so long as optimism
reigned; only after speculators' attacks on currencies helped
spread fear through global financial markets did spooked
investors pull their money out of virtually all emerging markets,
whether there was any real risk to their investments or not.
''In 1996 capital was flowing into emerging Asia at the rate of
about $100 billion a year; by the second half of 1997 it was
flowing out at about the same rate. Inevitably, with that kind of
reversal, Asia's asset markets plunged, its economies went into
recession, and it only got worse from there,'' summed up Paul
Krugman, a leading economist at the Massachusetts Institute of
Technology, in an influential current Fortune magazine article
endorsing currency controls as a short-term remedy.
In an effort to stop the global economic crisis from spreading, for
the past year the IMF -- led by the U.S. Treasury Department --
urged foundering nations to enact austerity policies, and especially
to raise interest rates high enough to lure back foreign investors.
That effort failed virtually everywhere. Meanwhile the high rates
crushed struggling businesses in a cycle that has plunged roughly
half the world into recession and is now threatening Latin
America.
Since the Treasury-IMF approach failed, imposing state controls
on currency markets is a reasonable Plan B for countries
struggling to stop their economic bleeding, a growing number of
experts say.
''They've got to get interest rates down, it's killing them,'' said
Lawrence Chimerine, chief economist at the Economic Strategy
Institute, a Washington think tank specializing in trade matters.
Short-term currency controls could help jump-start stalled
economies, Chimerine said, especially if combined with relaxed
IMF austerity conditions and a move by the Federal Reserve to
cut U.S. rates, which would ripple around the world.
How controls work
Full-scale currency controls work like this: The national
government requires domestic exporters to sell their earnings in
foreign hard currencies to the central bank at a fixed rate of
exchange for the national currency. The bank then uses the
hard-currency reserves to pay for imports and to service foreign
debts at the same fixed rate.
The government is then free to cut interest rates at home without
fear that the move would cause its currency value to plunge and
thus raise the dollar value of foreign debts and imports. Lower
rates give domestic businesses affordable credit and a chance to
revive.
There are many downsides to such a system, economists agree.
First, it deters foreign investors. Second, it requires inefficient
bureaucracy. Third, it tends to break down over time as
exporters hide earnings and importers cut secret deals.
Yet China has lured massive foreign investment despite such
controls, and its freedom from currency-market pressures has
permitted it to keep interest rates low and thus largely to escape
the crisis sweeping the rest of Asia, Krugman noted.>
Halfway controls can work too. Chile, for instance, taxes
businesses for short-term borrowings abroad, discouraging
excess debt. Brazil once taxed short-term foreign investments in
its stock market. Other nations have required foreign investors to
pay fees into a kind of insurance fund to discourage capital flight.
Such growing state interference in capital markets alarms some
observers.
''If the non-free market approach begins to take root again
across the world, the flow of money, trade, information and
culture that has fertilized this incredible period in world history will
dry up,'' warned Richard Medley, a Wall Street consultant, in a
recent essay.
But more dispassionate analysts say currency controls alone are
not that threatening.
''This is not the same as free trade in goods and services,
because these (financial) markets are subject to high volatility and
destabilizing speculation,'' said Jagdish Bhagwati, a renowned
free-trade theorist at Columbia University.
'Not free trade'
''That's what leads to this crisis. This is really a different kind of
market. Expectations can lead very rapidly to panic and so on.
Economic problems can flow from financial mobility, but that's not
free trade,'' which history proves is comparatively orderly and
mutually beneficial to buyers and sellers, Bhagwati said. He
added, ''My only worry is that if countries can't manage all this,
we're going to give global free trade (in goods and services) a
bad name.''
Currency controls used to be standard everywhere. Even the
United States maintained some controls on currency exchange
until 1974, and West European nations did not end them until well
into the 1980s. The world's leading economies slowly adapted to
wide-open financial markets only as free-market ideology swept
the world and computers made global capital movement
instantaneous.
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