Lawrence B. Lindsey

This selection was originally published in the New York Times on 6 January 1998. Lawrence Lindsey, a resident scholar at the American Enterprise Institute in Washington, D.C., is a former governor of the Federal Reserve System.

Suppose your brother-in-law announced to the whole family at Christmas that he had lost a bundle on Wall Street, couldn't meet his margin calls, and didn't have the money to meet either his credit card bills or his mortgage. Would you bail him out?

Your answer would probably be, "It depends." While the issues involved in the international bailout of South Korea (and other countries) are complex, some of the questions you would ask yourself about your brother-in-law aren't much different from the ones we should be asking ourselves about South Korea.

First, how did the debt burden get so large? In South Korea's case it was a web of sham accounting standards. The reported size of South Korea's exposure has mushroomed over the last several months. Last month [December 1997] the Korean government gave a "final" estimate of $160 billion, and that is just international debt; it doesn't include what Korean companies owe domestically. It is as if your brother-in-law lied to his broker about his assets, cheated on his mortgage application by misrepresenting his income, and then used one credit card to pay off the other.

Second, was the money used for a good purpose? In South Korea's case the loans were used to finance economic development and build an industrial infrastructure. There is no question that this is worthy. Unlike other countries we have bailed out, South Korea did not go on a consumption binge. In 1995, only about 10 percent of its total imports were consumer goods. The rest were capital goods to build productive capacity and raw materials and energy to drive those factories. Furthermore, Koreans work very hard. The great majority work six-day weeks, and it is easy to be impressed with their dedication and sacrifice.

Those investments, however, were made without much thought about the risks involved. The job of the Korean banking system was to say yes if one of the giant chaebols [corporate conglomerates] that run the economy asked for money. Under a web of protectionism and cozy relations with the bureaucracy, none of these companies ever got into trouble, even though their profit performance was poor. The national purpose was rapid industrialization and growth; gaining market share was the objective.

Assume your brother-in-law did not buy fancy consumer goods with his money. He used the proceeds from his home refinancing and his credit cards to build a position on Wall Street, which he leveraged further by using his margin account. Like South Korea, he was trying to get rich quickly, but he ran into trouble.

Third, what signals are sent if you finance the bailout? The Korean bailout is all being done very publicly. The United States Treasury and the International Monetary Fund are telling the other nations of the world that they will be the lenders of last resort. Consider Mexico, which is being touted as a success. The money that flooded into the countries now in trouble really started flowing after our bailout of Mexico. The interest-rate markups were unusually low for the supposed risk on these loans, and the greatest financing binge in world history quickly followed.

Remember, it is not South Korea that pockets the bailout money but the large multinational financial institutions that get paid back. They presumably lent this money in the expectation of making a profit. Their job was to make sure of the creditworthiness of the people they lent to. They could have insisted that the accounting standards of their customers be cleaned up. They didn't and lost.

Interestingly, American banks that were forced by the Federal Reserve and other regulators to accept more careful risk assessment standards and build their capital base were much less exposed to South Korea than European or Japanese banks. When lenders are burned on bad loans, they become much more cautious the next time around.

Back to your brother-in-law. Since everyone will know that you bailed him out, what will be the effect on your siblings, aunts, uncles, and cousins? Will they borrow more and assume that they can count on you? For that matter, will your brother-in-law have learned his lesson? And, if all of the lenders in the country know that there is someone in every family just like you, will they supervise the loans they make as closely?

Finally, what happens if there is no bailout? Unable to get their money, the creditors take possession of the companies, factories, and machinery that their loans financed and look for a new owner. The new buyers aren't necessarily part of the same bankrupt crony system; they are the ones who will pay the highest price. They may be American entrepreneurs or Koreans who have been on the outside in the past.

If the creditors can't get all their money back, they will take the loss and be forced to be much more cautious the next time. In some cases these losses may be quite large, and the regulators of these banks may be forced to take some remedial action (though these same regulators let their wards get overextended in the first place).

However, this route is far preferable to a bailout; both the South Korean and the world economies will be much better off. In South Korea, there will be much more competition and a greater focus on the bottom line. New credit will flow to the new owners much more easily than it would ever flow to the old deadbeats. All the "conditions" supposedly negotiated by the IMF will be forced on South Korea by the market.

The parallel to our home-front analogy is this: Not wanting to see your relations on the street, you might consider your brother-in-law's house a good asset, assume the mortgage from the bank, and allow him to pay you back. Let the other creditors get burned.

Rest assured, though, that you will have a lot more control over your in-law's behavior when you hold the mortgage on his house than if you simply bail him out. Not to mention the chances that Aunt Sally will need a bailout next Christmas will be substantially reduced.