This selection was originally published in the Wall Street Journal Commentary, July 20, 1999. Charles Wolf Jr. is a senior economic adviser and corporate fellow in international economics at RAND and a senior research fellow at the Hoover Institution.
In the past two years, major financial quakes have struck three geographically separate areas: East Asia in July 1997, Russia in August 1998 and Brazil in January 1999. In the Asian “crisis” countries–Thailand, South Korea, Indonesia and Malaysia–asset values plummeted by about 75% due to the combined effects of currency depreciations and deflated property and equity markets. In Russia and Brazil, the asset deflations were more than 70% and 50%, respectively. To place these tectonic crunches in another context, it’s worth recalling that in the U.S. financial crises of 1929-32, 1962 and 1987, the Standard & Poor’s 500 fell by 87%, 28% and 34%, respectively.
The explanations–and proposed solutions–fall generally into two camps. The first camp–Milton Friedman, Walter Wriston and George Shultz among them–contends that the crises were due to departures from the operation of free markets. The second camp–which includes financier George Soros, economist Paul Krugman and Malaysian Prime Minister Mahathir Mohamad–blames “untrammeled” markets and offers various regulatory interventions–a new “financial architecture”–to avert future crises. The latter camp has enjoyed the support of the Group of Seven nations, the International Monetary Fund and the Clinton administration.
As the crisis countries attempt to work their way out of the mire, those that are succeeding are doing so along the lines prescribed by the free-marketers. This comes as no surprise to the citizens of the countries affected by the crises. In a recent poll of six Asian countries by Japan’s prestigious Dentsu Institute, most respondents named failed government policies as the “foremost cause of the crisis.”
The Asian financial meltdown was nurtured by the widespread belief that nonmarket interventions (either from local governments or international institutions) could be expected to come to the rescue in the event of a crisis. The result was to encourage moral hazard. Such actions as short-term borrowing (and lending) and interest-rate arbitraging could be promoted with what was thought to be minimal risk. Asia’s crony capitalism meant resources were allocated not through fair assessments of market risk and realistic expectations of profit and loss, but rather according to the preferential status of sectors, firms and individuals.
The experiences of both Russia and Brazil reflected other sorts of evasions of market discipline. In Russia, the state’s centrally owned assets were distributed to a handful of favored oligarchs through government fiat, insider dealing and outright fraud, rather than through open, competitive bidding. The ensuing massive flight of capital from Russia, lubricated by IMF bailout funding, depreciated the ruble by more than 60% and sharply depressed stock values.
Brazil departed from the market regimen in several ways, not least by running large budget deficits while pegging its currency, the real, at an unrealistic rate. In response, investors predictably shorted the currency and took their capital abroad. As in Russia, the result was sharp currency depreciation and asset deflation.
Yet despite abundant evidence of its own complicity in the crises, the IMF has continued to insist on expanding its role, most recently by establishing a new Contingent Credit Line facility. Backed by a $90 billion replenishment of IMF resources, the CCL is intended to provide preventive loans to potentially vulnerable economies in order to forestall future financial crises.
The problem with this scheme is that it could easily aggravate the very ills it is intended to relieve. It’s readily conceivable, for instance, that the existence of the CCL will induce its prospective beneficiaries to “game” the credit line to obtain subsidized funding that existing capital markets would not provide. And countries that draw on the CCL may thereby signal their vulnerability to the markets and thus precipitate the very crisis they were trying to avert.
Better to allow the self-correcting processes of the market to operate in the event of crisis. Creditor institutions could choose to bear collective responsibility for deciding whether to incur an actual default on debt owed to them. Alternatively, they could form a consortium and share in providing roll-over financing, subject to conditions established by them rather than by governments. Free-rider temptations within the consortium could be mitigated by granting it temporary exemption from antitrust liability, allowing it to develop its own means of maintaining compliance within the group.
Another possibility–a modified version of an idea suggested by Mr. Soros–is to set up a multilateral International Credit Insurance Corp. to provide loan guarantees for emerging-market borrowing. This could work if the corporation were funded by charging performance-based premiums. Such a premium schedule would ease, if not fully resolve, the moral-hazard problem. Risky behavior would, over time, be penalized by higher premiums for loss-prone buyers of the loan guarantees.
In the aftermath of the crises, those countries that instituted market-oriented policies have managed to turn the corner. Foreign direct investment has resumed in reform-minded Thailand and South Korea, and Brazil, which has restrained deficit spending, has seen its foreign-exchange reserves, equity markets and currency value rise. Meanwhile, Russia, Indonesia and Malaysia, which have shunned market-oriented policies, continue to suffer sharp declines in gross domestic product, weakened currencies (in Malaysia temporarily buoyed by capital controls) and depressed asset values.
More freedom, rather than more intervention, is the path to economic recovery and sustained growth. But so long as the interventionists retain the upper hand in the councils of Western governments and multilateral organizations, the international economy will be prone to financial as well as moral hazards.