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Braudel
Papers - Nº 20 , 1998
1. Buttons,
Bubbles and the Yen
"Events are like fireflies in the Brazilian night:
they shine but fail to light the way," Fernand
Braudel observed six decades ago, when his car broke down
on a lonely road in the back country of Bahia. This
certainly is true of the events issuing from the
worldwide proliferation of financial assets that spawned
the Asia crisis, leading to the difficulties faced by the
world economy today. In the first part of this essay
(Braudel Papers No. 19), we observed that some countries
face stark choices like that of Argentina in its banking
and foreign debt crises of 1980-82, of either defaulting
or inflating away the stock of domestic debt or allowing
their economies to shrink severely. Since then, the video
game of Money, Greed, Technology has generated much
higher stakes. As fear enveloped the annual meeting of
the World Bank and International Monetary Fund (IMF) in
Washington, President Bill Clinton warned that "the
world faces perhaps its most serious financial crisis in
half a century."
Reaching beyond the light of fireflies, we will try to
explore these experiences in more depth and suggest some
policy initiatives to deal with dangerous proliferation
of financial assets. In recent months, until the typhoon
of the Asia crisis attacked Russia and Brazil in
August-September 1998, the center of the storm was in
Japan. Japan's troubles began with the rise of the yen
and the opening of its financial markets, both
accelerating in the 1980s. In the winter of 1986, Japan
was becoming the moneybags of the capitalist world. Its
troubles were beginning when I visited Tanabe, an old
castle-town and fishing port (population: 70,000) on the
southern tip of Honshu island, where button-making began
in the 1880s when a German engineer taught local farmers
how to cut and punch holes in shells gathered by
fishermen. By the 1930s Japan became the world's leading
exporter of buttons.
While Japan's flagship exports before the Second World
War were silk and cotton products, the great
psychological impact on world markets was created by
smaller industries. In 1932, factories with less than 100
workers generated 64% of Japan's exports. Shipments of
toys began in the 1890s and buttons in the foreign trade
bonanza bred by World War I. By 1935, Japanese
microscopes were being landed in Boston for $1.95 each,
duty-paid, while the American equivalent wholesaled at
$7.50. In Chile, English-style bicycles, made in Japan,
were selling for $8 each, half the price of the cheapest
German competitor, as bicycle exports surged from 3
million in 1929 to 23 million in 1937.
In Tanabe, the button industry was caught in one of the
typhoons that often attack the Japanese economy and
change its face. The "Nixon shock" of 1971
ended the Bretton Woods international monetary system of
fixed exchange rates and dislodged the postwar dollar-yen
peg ($1=¥360) that enabled Japan to export so
prodigiously. The price of the postwar yen bore no
relation to the exchange rate used by Japan to become a
major trading nation during the First World War and the
Depression. The U.S. military occupation decided
politically to peg the yen in 1949, fixing it at 360 to
the dollar (US$0.0028), against a trading average of 40
U.S. cents between the two World Wars. The big difference
between the prewar and postwar yen was to compensate for
wartime and postwar inflation and for the wreckage of the
Japanese economy. "We wanted the Japanese to be able
to export," Tristan Beplat, a financial affairs
officer for the occupation, told me. "We wanted them
on our side politically. In 1949 Japan was wrecked by war
and ravaged by hunger and inflation. We figured that 90%
of Japanese exports could sell at a ¥300 exchange rate,
even though some were profitable at ¥200. But we didn't
want to be wrong on such an important matter. So we
finally set the rate at ¥360. To get exports started, we
arranged a bank credit for buying cotton in California
and sent trade missions to the Philippines, Indonesia and
Brazil to round up other raw materials."
In a dramatic Sunday night televised speech on August 17,
1971, President Richard Nixon announced the end of the
dollar's parity with gold as part of a New Economic
Program that embraced a wage and price freeze, a 10%
import surcharge and tax cuts aimed at protecting jobs
while curtailing inflation and the U.S. balance of
payments deficits. The postwar expansion of dollar
liquidity outside the United States doomed the dollar's
link with gold. Treasury Secretary John Connally demanded
a 20% revaluation of the yen, then told his fellow
finance ministers of his fear that Japanese Finance
Minister Mikio Mizuta might commit hara-kiri if pressed
too hard. After much haggling, Mizuta agreed to a 16.9%
revaluation, calling it "the greatest economic shock
that Japan had experienced since the end of the World
War." By early 1986 the dollar had weakened to ¥175
and the yen's strengthening threatened the survival of
traditional export-oriented industries in many small
localities. MITI (Ministry of International Trade and
Industry) had a long list of them: pins and needles,
dishes, fish hooks, toys, Christmas decorations,
bicycles, flatware, eyeglass frames, chains, cigarette
lighters and buttons.
"I got a telex from America this morning asking for
a 20% discount because of the high yen," said Teruo Kanaya, the gray-haired king of Tanabe's button-makers,
owner of the factory his father started in 1919, who
prided himself on his knack of reacting quickly to
changes in the world situation. "After I heard about
the Nixon Shock, I got on a plane for America to talk
with my customers about billing my shipments in yen
instead of dollars. We worked out a 50-50 deal to share
the cost of the high yen equally between supplier and
customer. But now we can't absorb any more of this cost.
In 1955, there were 50 button factories in Tanabe. Now in
1986 there are only 10. In 1968, with the yen still at
360, we exported 60% of our buttons. Last year, with the
yen at 230, we exported only 20%. We used only Japanese
machinery 20 years ago. Now we use Italian machinery. Now
many poorer countries are buying these Italian machines
as well. From now on we'll concentrate on the domestic
market. We're lucky that the price in Japan is 40% higher
than the export price."
Many Japanese manufacturers of buttons and Christmas
decorations opened factories in countries like Thailand
and China. They switched into new businesses at home
while their employees now staff beauty parlors and
supermarkets as part of the worldwide shift of employment
from industry into sales and services. "In 1972 a
Spanish button-maker visited me and, after years of
talks, we set up a joint-venture factory outside
Barcelona," Kanaya said. "We are working to
build market-share in Europe and maybe export to Africa.
You know, Spaniards are very hard workers. Their wages
are half what we pay in Japan. And the price of factory
land is only one-fiftieth as much. Here in Tanabe, I plan
to go into the food business, which is growing."
But many small Japanese manufacturers were left behind in
the backwash of yen revaluation. After the dollar fell to
¥150, sales collapsed from $1 million in 1985 to
$300,000 in 1987 at Takao Suzuki's three-employee machine
shop in Tokyo's Ohta Ward, where some 6,000 family-owned
workshops bang out parts for big companies like Hitachi
and Mitsubishi. Then banks began pressing him to borrow.
"Bank of Tokyo-Mitsubishi [then Mitsubishi Bank]
came around and begged us to take out a loan,"
offering $1.2 million, Suzuki recalled. "I asked,
'What would I use that money for?' The man said: 'Buy
stocks!' So I did." Then the stock market collapsed
and Suzuki dumped his shares at a big loss. Now he owes
nearly $2 million, more than 10 times his expected sales
for 1998, to five banks, four of which have claims on a
small building that Suzuki pledged as collateral before
property values also collapsed. Instead of foreclosing,
the banks keep rolling over Suzuki's loans, cutting
interest rates and lending new money. Hundreds of
thousands of bad bets like these now burden the economy.
So Japan's banks are in deep trouble.
Despite troubles with buttons, Japan was accumulating a
large cash hoard from trade surpluses earned by its
advanced industries. By early 1995 the dollar cheapened
to only ¥80, a 450% devaluation from the Bretton Woods
parity, before it recovered to ¥140 in early 1998. By
then Japan had sunk into a financial and political
malaise in which its elite officialdom displayed little
of the agility and realism showed by the button-makers of
Tanabe. Japan's nominal per capita income rose from $138
in 1950 to $41,000 ($23,000 in terms of comparative
purchasing power) by 1996. Despite its affluence, Japan
has been shackled by a mysterious institutional
paralysis, now fashionably called "the Japanese
disease." Political reform has come and gone in the
1990s, returning power to the faction-ridden leadership
of the Liberal Democratic Party (LDP), which has ruled
Japan for more than four decades but now cannot contain
the decline in respect for Japan's public institutions.
The LDP has been disgraced by political and financial
scandals, weakening long-revered bureaucratic authority,
in the banking crisis of the 1990s that has left Japanese
banks with bad loans estimated at $1 trillion. "The
banks have run out of reserves available to write off
non-performing loans," observed James Fiorillo of
ING Baring Securities (Japan). "In fiscal 1998,
Japanese banks will have to write off and set aside ¥10
trillion ($74 billion). But they can spend just ¥5
trillion." The shortage of bank funds to tackle the
bad-loan problem forced the government to use public
money to help banks to reduce bad loans. The bad loans of
Japan's 19 biggest banks average 180% of their equity
capital. According to Robert Feldman of Salomon Brothers,
"the levels of all three key properties of financial
assets -return, safety and honesty- have deteriorated in
the Japanese financial system in the 1990s."
The rise and fall of Japanese
asset prices in the decade after 1985 was a classic
financial bubble, one of the most spectacular in history.
The Nikkei stock index surged from 13,000 in December
1985 to 39,000 four years later, only to fall by 60% in
1990-92. In yen terms, stock market capitalization rose
to 1.6 times Japan's whole GDP, against less than half of
GDP in 1982 and three-fourths in 1985. Stock prices were
linked to land prices, which increased by more than
Japan's whole national product in 1987. By 1990 the
market value of all the land in Japan was four times the
land value of the United States, which covers 25 times
the area of Japan. Prices of land and stocks were closely
linked, rising and falling together, fueled by credit and
investments from the financial system. By 1995, land and
stock prices returned to where they would have been on
the ascending trend curve set from the mid-1970s to the
mid-1980s, as if the bubble were just a dream. However,
this dream left a hangover of bad debts that deeply
damaged Japan's self-confidence and the credibility of
its financial and political institutions. Debts left
behind by corporate insolvencies in fiscal 1997, rose 65%
to $116 billion, the most since World War II, only part
of the colossal waste of capital.
In The Migration of British Capital to 1875 , Leland
Jenks warned in 1927: "Age-old systems of culture
and reflection may at long last owe survival or decay to
the manner in which the invested capital is
applied." As it accumulated a household savings pile
of some $10 trillion today, 60% of the world's net
saving, Japan evoked hopes that it could play a role like
Britain's in the 19th Century, generating as much as 10%
of its GDP as foreign investment to finance modernization
of the world economy. Japan pumped investments totaling
some $1.5 trillion into the world economy since 1985,
becoming the world's leading capital exporter, as was the
United States in the 1920s. In doing so, Japan collided
with the institutional problem of managing
fast-escalating financial assets, as did the United
States in the 1920s, which is the basic issue behind the
Asian crisis today. Japan's problem is wasted financial
resources, evoking comparisons not with 19th Century
Britain but with 16th Century Spain, which failed to
employ its New World silver productively.
The Japan bubble was an extreme but not an isolated
event. Financial liberalization in Japan excited a
banking, real estate and stock market boom, as did
liberalization in many other countries. Inflation
remained low, thanks to the strong yen, as wholesale
prices fell by 20% in the decade since 1985. But monetary
policy was loose. The broad money supply grew by 10.5%
yearly in 1985-89 while the Bank of Japan, worried about
the yen appreciating too fast against the dollar, cut its
official discount rate five times, from 5% to 2.5%.
Trends toward lower interest rates in the United States
and Japan reinforced the escalation of asset prices. The
dollar lost 40% of its real value after the 1985 Plaza
Agreement between leading finance ministers to end
overvaluation of the dollar. The U.S. cut its key federal
funds rate from 10% in 1984 to 3% in 1993, spurred
further by efforts to save the real economy from the
effects of the 1987 stock market crash and an epidemic of
bad real estate loans in the banking system. Like the
Federal Reserve in the United States before the 1929
crash, the Bank of Japan was blamed for cutting interest
rates too fast and too much in 1986-87 and then for
delaying interest rate increases too long before the
bubble collapsed.
As asset prices fell, the Bank of Japan, attempting to
revive a stagnating economy, cut interest rates 10 times
since 1991 to the current low of 0.25%. Japan's long-term
bond rates fell to 1.07%, a historical record, breaking
the previous low of 1.125% set by Genoa's municipal bonds
in 1618. However, low interest rates failed to stimulate
new borrowing and lending because of spreading fear,
excess capacity in commerce and industry and deepening
institutional concerns that the political system had
failed to resolve. As conditions deteriorated, Japan's
regulators helped banks and brokerage firms to hide their
problems. In 1991-92, the Finance Ministry adopted a
"forbearance policy," allowing banks to hold
nonperforming loans without special writeoffs, using
creative accounting, in hope that asset prices would
revive. Banks' dividend payments actually increased
despite declines in earnings. In 1995 the Finance
Ministry helped Daiwa Bank hide $1.1 billion in losses
that one of its New York bond traders amassed over 11
years, resulting in a Federal Reserve order for Daiwa to
close its U.S. operations later that year. Finance
companies known as jusen , funded by banks and farm
cooperatives, collapsed with real estate prices in ways
akin to the U.S. savings & loan failures of the late
1980s and early 1990s. The government paid off the
politically-powerful farm cooperatives to recover their
loans to the jusen in full and let the banks keep the bad
loans on their books.
Until recently, everyone resisted a distress sale of
property to clear the market, as was done by the U.S.
Resolution Trust Corporation (RTC) after 1991. As Martin
Mayer observes, these distress sales "recreated the
markets. The first buyers made immense profits, which
brought in new cadres of bidders for subsequent auctions,
and the reviving markets launched the great expansion of
this decade. The sale of overvalued assets from failed
banks, at distress prices, creates sound assets for
surviving banks, reviving their willingness to
lend." Yukiko Ohara of the Tokyo branch of UBS
Securities added: "In the U.S., banks proceed with
their restructuring because of strong pressure from the
Federal Reserve Board and the stock market as well as
pressure to raise funds. But here the government provides
public funds and prevents the stock market from falling,
thus delaying much-needed restructuring." Finally,
under foreign pressure, the Japanese government in July
1998 announced a "Total Plan" to solve the bank
crisis by closing failed institutions, turning their
clients over to new government-run "bridge
banks" to keep credit flowing and accelerating sale
at current depressed prices of real estate held as
collateral for bad loans. Bank inspection would be
intensified and financial disclosure increased. Under
this scenario, hopelessly indebted firms like Takao
Suzuki's Tokyo machine shop would close, many people
would lose their jobs and financiers could be prosecuted
for misconduct. "Bridge banks" would be created
by a new agency, the Deposit Insurance Corporation,
modeled after the RTC, which sold real estate collateral
of failed banks in the U.S. savings and loan crisis. They
would draw on a huge government bailout fund to pay
depositors and subsidize bank mergers. However, the U.S.
S&L crisis was spread among hundreds of small banks,
while the bursting of Japan's bubble severely weakened
big money center banks as well as the small ones, making
mergers more difficult. Many observers doubt that these
plans will translate into real action and real losses
with high political costs. But they were greeted with
enthusiasm by the heavily-indebted construction industry,
a major force in mobilizing electoral support for the
LDP. This industry generates six million jobs and is set
to receive $55 billion in emergency public works
contracts as part of the government's economic stimulus
package.
Pressure for decisive action grew after failures and
scandals began to multiply in late 1997. The bankruptcy
of century-old Yamaichi Securities, one of Japan's Big
Four brokerages, involved $2.1 billion in off-the-books
debts. Yamaichi's president was seen on television
throughout the world profusely weeping and apologizing
for the firm's failure. Yamaichi started shifting losses
to subsidiaries and dummy corporations in 1991 after a
scandal revealed the Big Four compensating privileged
clients for stock market losses, a standard practice in
the past. Meanwhile, 32 executives of the Big Four and
the big Dai-Ichi Bank are on trial for making illegal
payments to the same financial racketeer of some $3
million each. The main bank in Hokkaido, Japan's northern
island, and another securities house, Sanyo, also failed.
The Bank of Japan's president and the Minister and Vice
Minister of Finance resigned after senior officials were
arrested for accepting bribes and lavish entertainment
from banks and brokers in exchange for leaks of
privileged information. Among those arrested were two
Finance Ministry inspectors who were publicly humiliated
when shown on television. These embarrassments provoked
eight suicides, all by hanging: a Bank of Japan executive
director investigating bribery and lavish entertainment
of employees, two Finance Ministry officials, a former
Finance Ministry bureaucrat who was elected to
parliament, a private bank executive and three
businessmen in financial distress. In early April, after
the Bank of Japan issued a survey of declining business
confidence, Sony's president, Norio Ohga, warned:
"Japan's economy is on the verge of collapse....I am
concerned that if Japan falls into a deflationary spiral
it would affect the Asian economies. In that case, not
even the U.S. economy would be able to maintain its
healthy state. Japanese politicians only look after their
own constituencies, they only work at a purely domestic
level. They have to aware of the global picture. If you
look at what Hoover was saying at the start of the Great
Depression and what [Prime Minister Ryutaro] Hashimoto is
saying at the moment, they are very similar."
Poor Herbert Hoover! This unlucky and much-maligned
President of the United States, one of the most brilliant
statesmen of his generation, took office only seven
months before Wall Street's Great Crash. Throughout the
1920s, as Secretary of Commerce, Hoover warned against
dangerous stock market speculation and preached
government anti-recession policies and mobilization of
private energies to reduce economic pain and raise
efficiency. He used new statistical and business cycle
research that found their way into official pep talks and
exhortations. When the 1929 Crash came, Hoover was ready
with a plan. He quickly went into action with a
three-prong program to sustain demand and keep the
economy moving: (1) more public works spending at all
levels of government; (2) low interest rates to ease
business investment and home-building (3) keeping wages
high to prevent a collapse of consumer purchasing power.
Within weeks of the Crash, Hoover launched into the most
forceful government effort to curb economic crisis ever
seen in modern times. He got Congress to cut taxes, got
business and labor leaders to hold the line on prices,
wages and capital spending and got the Fed to ease credit
by lowering interest rates from 4% to 1.75%, the lowest
on record. As the Depression deepened, he created the
Reconstruction Finance Corporation, which tried to
recapitalize banks by buying their preferred stock.
"The ideas embodied in the New Deal legislation were
a compilation of those which had come to maturity under
Hoover's aegis," wrote Rexford G. Tugwell, a key
adviser to President Franklin D. Roosevelt [1933-45].
"The Hundred Days [of aggressive reform as soon as
Roosevelt took office] was the breaking of a dam rather
than the conjuring out of nowhere of a river."
In fairness, it must be said that former Prime Minister
Hashimoto enacted some emergency measures that Hoover
took at the start of the Depression, but with a
difference reflecting the depth of Japan's institutional
crisis. The LDP announced a $120 billion fiscal stimulus
package, the seventh in six years and the biggest yet,
all of which failed to revive the economy but pumped
money into troubled construction companies that have been
big campaign contributors to the LDP. Local governments,
running big deficits, also refused to spend more on
public works. By October 1998 the stimulus effort was
stretched to issuing $220 gift vouchers to each citizen
and decreeing "Happy Monday" holidays to give
people more time to shop.
By then Japan had launched its Big Bang: scores of
financial reforms, embraced in a 10-pound, 2,132-page
tome working its way through parliament that, ending
traditional protectionism of financial markets, would
allow Japan's citizens to invest freely abroad, using
foreign securities firms. So $20 billion monthly has been
flowing from Japan into overseas accounts as the Big Bang
provides access to higher-yielding mutual funds as an
alternative to individual savings accounts yielding
annual interest of only 0.25%.The new rules also abolish
functional barriers between banks and brokerages,
encourage insolvent institutions to close down and allow
brokers to start their own mini-exchanges to compete with
the Tokyo Stock Exchange. Despite all this action,
Hashimoto was caught between efforts of some LDP factions
to drive him from office and Keynesian nostrums of
foreign politicians, economists and journalists to do
more to revive the Japanese economy. So Hashimoto
announced another $16 billion in tax cuts, but wavered in
their implementation. Japan's politicians and public
still refused to pay the short-term political and fiscal
cost of closing insolvent banks. Why? Because survival of
so many people and companies is at stake. Not only banks
are in trouble, but thousands of businesses as well.
Under intense foreign pressure, the Diet in October 1998
finally passed a $500 billion bailout of the banking
system without clear provisions for how the money will be
used.
Some Japanese journalists called the U.S. imposition of a
stimulus package a "second defeat." Television
coverage of U.S. Deputy Treasury Secretary Lawrence
Summers's arrival at Narita airport in June 1998 was
mixed with old film clips of General Douglas MacArthur
landing at Atsugi airfield in 1945. U.S. foreign economic
policy is run by the best and brightest of Wall Street
(Treasury Secretary Robert Rubin of Goldman, Sachs) and
academia (Summers of Harvard), both of whom were publicly
scornful at what they saw as Hashimoto's dithering in
response to foreign pressure to clean up the banks and
stimulate demand.
In preaching to Japanese politicians, foreign economists
may not understand that they are assigning them a
difficult if not impossible task. A government cannot
concurrently "stimulate the economy" while
collapsing much of the financial structure as it
"cleans up the banks," wiping out hundreds of
billions of dollars of dubious assets approaching 30% of
GDP and breeding big increases in bankruptcies and
unemployment. The recipe of tax cuts and more deficit
spending could make problems worse, aggravating an
already critical fiscal problem and further undermining
the credibility of public institutions. It is hard to
weigh the influence of Washington's ire on the LDP's poor
showing in the July 1998 election for the Diet's upper
house, prompting Hashimoto's resignation. In what
normally is a low-turnout kind of election, urban voters
cast ballots massively against the LDP, which failed to
win a single seat in Japan's four biggest cities (Tokyo,
Osaka, Yokohama and Nagoya), overwhelming the LDP's
traditional base of rural and elderly voters. "The
message voters wanted to send in the upper house
election," observed political scientist Yoshiaki
Kobayashi, "is criticism of the Japanese-style
system of redistribution -in particular criticism of
excessive spending that leaves the check to future
generations." If voters wanted an end to deranged
economic transfers, that is not what they apparently got.
Hashimoto's successor was Keizo Obuchi, a member of the
LDP's biggest faction, led by Noboru Takeshita, which is
backed by the construction industry. Both Takeshita and
the new Finance Minister, 78 year-old Kiichi Miyazawa
presided over the bubble economy of the late 1980s as
Finance Minister and Prime Minister. We do not know if
financial troubles in the near future will disrupt the
gerontocracy that governs Japan's corporate and political
affairs, rooted in a population with more adults over age
65 than children under age 15.
Given these rigidities, we cannot agree with those
economists who think they can make variables dance in the
way a symphony orchestra responds to a conductor's baton.
The economics profession performs useful tasks of
measurement, history and theory, but often has been
confused and contradictory in recommending economic
policy. J.M. Keynes, not a humble man himself, urged
humility on his profession: "If economists could
manage to get themselves thought of as humble, competent
people, on a level with dentists, that would be
splendid!" Nevertheless, one of the stars of the
profession, MIT's Paul Krugman, intrepidly recommends a
policy of sustained inflation to the Japanese government.
In his widely read home page on the internet, Krugman
argues: "Japan is in the dreaded liquidity
trap," with excess savings, near-zero short-term
interest rates and the Bank of Japan expanding its
balance sheet at a 50% annual rate. So what does Japan
need? More liquidity, of course! According to Krugman,
"the simplest way out of the slump is to give the
economy the inflationary expectations it needs. This
means that the central bank must make a credible
commitment to engage in what in other contexts would be
regarded as irresponsible monetary policy -that is,
convince the private sector that it will not reverse its
current monetary expansion when prices begin to
rise!" Thus inflation would make interest rates
negative, discouraging savers from holding financial
assets and driving them to consume. Krugman then parades
a series of mathematical equations to impress and
persuade the cognoscenti. But he writes himself an escape
clause at the end of his essay: "Of course, it is
not necessary that Japan do anything....A dynamic
analysis makes it clear that [the liquidity trap] is a
temporary phenomenon -in the model it lasts only one
period, although the length of a 'period' is unclear (it
could be three years, or it could be 20). Even without
any policy action, price adjustment or spontaneous
structural change will eventually solve the problem. In
the long run Japan will work its way out of the trap,
whatever the policy response."
Krugman's discussion is important for two reasons. First,
it revives the old idea, familiar to us in Latin America,
that a little inflation is a good thing. The trouble with
this idea, which some economists incorporated into
development theory in the 1950s and 1960s, is that
inflation creates powerful vested interests and
institutional mechanisms of its own and, once unleashed,
is very hard to control. If the idea were to become
fashionable again, endorsed by fashionable economists
like Krugman, desperate politicians and their acolytes in
economics profession could undo the long and so far
successful struggle to institutionalize price stability
and democracy in countries like Argentina, Bolivia,
Brazil, Chile, Mexico and Peru. This would be a terrible
price to pay for a temporary expedient.
Secondly, Krugman's fallback position ["Even without
any policy action, price adjustment or spontaneous
structural change will eventually solve the
problem."] also carries a lesson. An overdue
retrenchment has stopped a worldwide expansion and
proliferation of financial assets bred on a scale and
duration never before seen. This retrenchment has left
financial businesses with large amounts of excess
capacity pending readjustment of asset values, impacting
other forms of economic activity. Readjustment must work
its way through the system. Fortunately, we are not
dealing with a synchronized collapse of asset values in
all major countries as in the Great Depression. However,
as Japan's recent experience shows us, failure to allow
markets to adjust asset values and shrink balance sheets
will only prolong the crisis. A lesson of the Great
Depression is that artificial stimuli are of marginal use
without deeper economic reorganization.
Economists and politicians are so obsessed with analogies
between Japan's recent bubble and collapse with those of
the 1920s and 1930s that they ignore closer parallels
with the greed and credulity of an earlier "bubble
economy," the South Sea Bubble of 1720, when much of
the English power elite -ministers, landowners, members
of parliament, even the king's mistresses- took part in
an orgy of speculation and swindles, so much that a major
political mobilization had to be mounted to preserve the
monarchy. The South Sea Bubble spurred a century of
administrative and political reforms that made English
government more honest and responsible. In Japan today,
as in England then, reform on this scale is unlikely to
be an overnight affair, as so many foreigners demand.
Murray Sayle, a veteran Australian journalist who has
lived with his family for the past two decades in a
mountain village 60 miles from Tokyo, blames Japan's
institutional paralysis on "ethno-economics":
The uglier aspects of the system, which so astonish
non-Japanese, all come from the same idea of Japan as one
big family. Bid-rigging on private and government
contracts is all but universal. Big firms get the big
jobs, little ones the scraps, but everyone in the family
stays in business. Japan has far too many banks, bars,
building contractors, mom-and-pop retailers and even post
offices for economic efficiency -but they provide a
living for other Japanese. Why are Japanese companies
obsessed with market share and unconcerned about profits?
Because market share means jobs for Japanese, while mere
shareholders have no right to meddle in management or
demand dividends. Owning up to the bad debts would have
shattered the dwindling public faith in the parliamentary
façade, the scandal-plagued LDP, whose share of the
overall vote was slipping. Only a strong, united
government can ever make real reforms anywhere; Japan's
was, and is, weak and divided, still feebly trying to
please everyone in the family.
As the political reformer Ichiro Ozawa suggested in 1992,
Japan may need a renewal akin to the Meiji Restoration,
when some samurai under the aegis of a young Emperor
overthrew the feudal Tokugawa shogunate (1600-1868) and
sought contacts with the West to acquire technological
and institutional equipment to resist foreign
interference and to launch Japan on its long-term path of
modernization and high economic growth. But the incumbent
power structure still may be too powerful for radical
renewal. Also, the aging of Japanese society may preclude
bold initiatives. In Murray Sayle's village of Hanbara,
some 350 houses spread along a mountain stream, a cult is
made of neighborliness and mutual help, but the village
is dying. Last year saw 17 funerals but only one wedding
and one birth in Hanbara. Fewer babies were born in Japan
in 1996 than in any year since 1897, when the population
was only one-third as large. Half of all women under 30
remain unmarried. Japan's elderly population over 60 is
projected to grow from 21% in 1996 to 30% in 2010.
Enormous sums are being spent in building nursing
facilities. Care for old people absorbs more and more
investment and manpower while working-age population
shrinks by 1% yearly. Birth rates fall in almost all
urbanized societies, but Japan's severe birth dearth is
aggravated by perverse incentives. Childbirths are not
covered by Japan's health system, so parents often must
pay the doctor $3,000 in cash before they can take their
baby home. Education is fiercely competitive and very
expensive, if the cost of the nearly universal
after-school cram courses is included. Despite decades of
public debate and worrying about aging population and
declining births, little has been done to remove these
perverse incentives. Foreigners clamor for more fiscal
stimulus and deficit spending, even though government
deficits already are at 7% of GDP, three times the
average of other major economies, and public debts
approach 100% of GDP and would be much higher if bank
losses and government debts to the postal savings system
were included. Meanwhile, many Japanese take a relaxed
view of economic decay. "People complain about the
bad economy," says Mitsuo Okura, who runs a small
plastics factory in a town 200 miles from Tokyo.
"But when I look around the house, I've got
everything I want. I've got three cars, and most people
around here have two or three as well. I've got a washing
machine and refrigerator, and so do all my neighbors.
Even if no one sees a bright future, there's no feeling
of crisis. Deregulation is inevitable. The challenge is
to figure out what to do with people like me. But if we
just say that new things are no good, then Japan itself
will be no good."
2."Santa
Claus is Dead"
Japan's banking problems, at the core of the Asia
crisis, must be viewed in broader perspective. Some $1.1
trillion of bad debts being carried by Japan's banks are
huge in both absolute and relative terms, at nearly 30%
of GDP, exceeding nonperforming assets in most recent
banking crises around the world. As cross-border
financial activity expanded and intensified since the
1970s, banking crises erupted in some 40 rich and poor
countries. Strikingly, the colossal failures of Brazil's
Banespa ($24 billion) and France's Crédit Lyonnais ($32
billion) in 1995 involved neither a currency crisis nor a
stock market crash. [See "King Kong in Brazil,"
Braudel Papers No. 15]. It also is striking that the
world economy has continued to grow and to reduce
inflation despite the financial turbulence of recent
decades.
This overall stability does not mean that our times have
been free of risk or loss. By the time Mexico defaulted
in 1982, foreign debts of developing countries totaled
$720 billion, or one-third of all Eurocurrency assets.
They embrace more than two-thirds of international bank
loans today. The cost of Mexico's current bank bailouts
is officially estimated at $65 billion, or 16% of GDP,
but private appraisals run much higher. In Chile, private
losses from the 1982 banking crisis totaled 28% of GDP.
In the United States, some 1,300 banks and 1,400 savings
institutions failed or were merged in 1980-91, against
only 210 closures in 1945-79. In 1991, assets of failed
U.S. banks totaled $66 billion, the most since the 1930s,
including 11 banks with assets of at least $1 billion.
According to Andrew Sheng of the Hong Kong Monetary
Authority, these failures embody "massive problems
of moral hazard in almost every country. Bank management
could and did take risks far beyond prudential levels
because losses were ultimately borne by the state. Under
perverse incentives and poor supervision, even good bank
managers became bad managers, engaging in speculation,
excessive spending and ultimately fraud."
What is our margin of security? Our method of security is
cooperation. "Prosperity has no fixed limits,"
U.S. Treasury Secretary Henry Morgenthau argued at the
start of the Bretton Woods conference in 1944, which
created the postwar international financial system.
"We know now that economic conflict must develop
when nations endeavor separately to deal with economic
ills which are international in scope. To deal with the
problems of international exchange and of international
investment is beyond the capacity of any one country, or
of any two or three countries. These are multilateral
problems, to be solved only by multilateral
cooperation."
Six decades later, as panic spread following Russia's
devaluation and debt default in August 1998, Federal
Reserve Chairman Alan Greenspan observed that "it is
just not credible that the United States can remain an
oasis of prosperity unaffected by a world that is
experiencing greatly increased stress....We take for
granted that contracts will be fulfilled in the normal
course of business, relying on the rule of law,
especially the law of contracts. But if trust evaporated
and every contract had to be adjudicated, the division of
labor would collapse. A key characteristic, perhaps the
fundamental cause of a vicious cycle, is the loss of
trust. We did not foresee such a breakdown in Asia. I
suspect that the very nature of the process may make it
virtually impossible to anticipate. It is like water
pressing against a dam. Everything appears normal until a
crack brings a deluge."
Our margin of security is embedded in the institutional
facilities provided to support countries in trouble.
These facilities are neither foolproof nor infinitely
elastic. The United States led every successful
international rescue effort from the Dawes Plan of 1924
to the Asian bailouts of 1997-98, yet caused major
disturbances when driven by domestic pressures, as when
it killed the Bretton Woods system of fixed exchange
rates in 1971 and raised interest rates in 1979 to stop
inflation and defend the dollar. "Santa Claus is
dead," Treasury Secretary George Schultz said in
1972, meaning that the United States would not act as a
global monetary savior if this meant weakening the
reelection prospects of President Nixon.
Every international financial crisis of the postwar
decades has been animated by fear, recrimination and
maneuvers to shift the burdens of adjustment from one
protagonist to another, as Britain did in the 1920s,
persuading the United States to lower interest rates,
facilitating the Wall Street stock market bubble, so the
Bank of England would not have to raise its own rates to
sustain an overvalued pound. Nevertheless, institutional
cooperation continued to evolve from one crisis to the
next. First came the original haggling over the terms of
the Bretton Woods agreement of 1944, establishing the IMF
and the World Bank. Then came the Cold War launching of
the Marshall Plan and creation of the OECD, followed by
the U.S. balance of payments deficits of the 1960s and
French President Charles de Gaulle's denunciation of the
"exorbitant privilege" used by the United
States to print dollars that enable U.S. companies to buy
European companies. These frictions contributed to the
end of Bretton Woods fixed exchange rates. Next came the
two oil crises of the 1970s and the recycling of
petrodollars, breeding the debt crises of the 1980s. A
new generation of problems were posed by the end of the
Soviet empire, while proliferation of financial assets
produced the Mexican peso crash and bailout of 1995, and
the East Asian crisis, beginning with the collapse of
Japan's bubble in 1990 and then today's troubles of
Thailand, Korea, Indonesia, Malaysia, Russia and Brazil.
"The world and its leaders tend to lurch dangerously
between two opposite poles: either an exaggerated belief
in the intractability of problems or an overconfidence as
to their solubility," observes Harold James in
International Monetary Cooperation since Bretton Woods
(1996). "Hubris and despair chase each other in
quick succession....The task of international
institutions, and of the surveillance process, is to
ensure that both are avoided and that problems are
analyzed, understood and then tackled."
The Asian crisis was deepening in September 1997 when
financial officials and financiers met in Hong Kong for
the annual meetings of the IMF and World Bank, when the
IMF Interim Committee endorsed an eventual move toward
capital-account convertibility -unrestricted movement of
money between countries. As the troubles of Thailand,
Indonesia, Korea, Malaysia and Japan worsened, this idea
drew an angry response from some leading economists.
Professor Jagdish Bhagwati of Columbia University, a
distinguished analyst and advocate of free trade in goods
and services, questioned the legitimacy and wisdom of
free capital movements among crisis-prone financial
markets, under the umbrella of a "capital myth"
created by "what one might christen the Wall
Street-Treasury complex....a definite networking of
like-minded luminaries among powerful institutions -Wall
Street, the Treasury Department, the State Department,
the IMF and the World Bank most prominent among
them." Indeed, discussion revived of an opposing
idea: restoration of capital controls. According to
Professor Dani Rodrik of Harvard University: "We can
imagine cases where the judicious application of capital
controls could have prevented a crisis or greatly reduced
its magnitude. Indonesia and Thailand would have been far
better off restricting borrowing from abroad instead of
encouraging it. Korea might just have avoided a run on
its reserves if controls on short-term borrowing had kept
its short-term exposure to foreign banks at, say, 30%,
rather than 70% of its liabilities. Which of the recent
blowups in international financial markets could the
absence of capital controls conceivably have
prevented?" Krugman proposed in an article in
Fortune (September 1998) that Asian countries use
exchange controls to deal with financial troubles, a
policy that Malaysia adopted a week later. The crux of
this debate lies in the different goals of modern states
and markets. Harvard's Richard Cooper contrasts the
"myopic behavior" of markets to the role of
modern states as guardians of welfare and stability.
"Because financial systems are not intrinsically
robust," he adds, "governments must concern
themselves with system maintenance."
IMF stabilization programs today follow the basic pattern
established in emergency loans by the League of Nations
in helping European countries, some of them created after
World War I, to overcome hyperinflation in the 1920s. The
League's small but brilliant staff of economists included
three future Nobel laureates. Of 24 countries suffering
high inflation then, only six (Austria, Hungary,
Bulgaria, Danzig, Estonia and Greece) entered League of
Nations programs to stabilize. Also, Germany, Britain,
Belgium, France, Italy, Romania and Poland received
bilateral credits from central banks. Nevertheless, in
his classic study of The Course and Control of Inflation:
A Review of Monetary Experience in Europe after World War
I (1946), Ragnar Nurske concluded that "the role of
foreign financial assistance in insuring the technical
success of exchange stabilization was a relatively minor
one. Loans and credits from abroad were neither
sufficient by themselves to bring about effective
stability of a country's exchanges, nor were they always
necessary to that end."
The IMF has been caricatured cruelly in dealing with the
Asia crisis. Jeffrey Sachs argues that "the IMF was
having too much fun running 80 countries in the world to
take heed" that international institutions
"have proved technically ill-equipped for the
challenge" of reviving troubled economies. While the
IMF may be criticized for secretiveness and details of
policy, no other agency has taken on the frustrating and
dirty job of stepping into chaotic situations, where
national governments have failed, trying to overcome
economic insanity and financial insolvency and to protect
the international payments system. As bailouts under IMF
programs since the outbreak of Asia's troubles neared
$180 billion, skeptics questioned the financial and
political capacity of the IMF to deal as generously with
future crises.
Russia's default, shortly after a $23 billion IMF-led
rescue package was announced, bred new fear. "The
investors' panic at the end of August 1998 came from
perception that confidence in the lender of last resort
in the world financial system, the IMF, was at an
end," observed Marcelo Allain of São Paulo's Banco BMC. The idea of a lender of last resort has an old
pedigree, going back to the Bank of England's rescue of
investors in the South Sea Bubble of 1720. In his classic
study of The Great Depression, 1929-1939, Charles
Kindleberger argued that "if the [bank] runs [in
1931] on Austria, Germany and Britain had been halted by
timely international help on a massive scale, the basic
recuperative powers of competitive markets would have
prevented the depression from going on so long and so
deep." However, financial distortions in both the
1920s and 1990s were allowed to grow so big that they
defied institutional capacity for rescue operations.
Long before default on its public debt and crash of the
ruble, Russia's bankruptcy was telegraphed by the surge
of mortality that followed the collapse of the Soviet
Union, impacting both sexes and all age groups,
especially men of working age. Male mortality rose by 53%
in 1990-94, reaching the levels of the most backward
African countries. Mankind rarely has experienced
mortality surges on this scale, associated historically
with wars, plagues and famines. A modest recovery took
place after 1995 as desperation and new opportunities
brought forth extraordinary efforts by people trying to
survive the collapse of communist central planning.
Starting from almost nothing, commercial networks
developed fast. The clearest sign of them was the sudden
proliferation of pre-fabricated kiosks outside subway
stations and in other open spaces in Russian cities.
Moscow's huge subway system became one of Russia's main
commercial arteries. Escalators were crammed and often
damaged by people dragging luggage carts loaded with
goods from one city location to buy and sell in small
arbitrage deals. The corridors at busy subway entrances
and transfer points were lined with people of all ages
holding up for sale pathetic quantities of cooking oil,
soap, electric wiring, bread and old books and magazines.
Their tenacity and bravery were as impressive as their
desperation. Millions of people went without pensions and
salaries as the government struggled to defend the
currency and hold down inflation, even as top managers
and financial "oligarchs" appropriated public
assets in rigged privatization deals. Russia's chief
auditor confirmed that billions of dollars in
international aid was stolen. Suffering from $500 million
to $2 billion in losses in Russian debt and derivatives,
Credit Suisse First Boston accused Russian companies of
generating $66 billion in capital flight in 1994-97.
Russia's tax system yielded only 10% of GDP, falling to
6% in the last quarter of 1998, less than Bolivia's level
of taxation on the eve of hyperinflation in 1985, clearly
not enough to fund a shaky government apparatus spread
over 10 time zones on the Eurasian land mass. So central
government crumbled. As ice closed in on Arctic Siberia
for the winter, supply ships stopped delivering food for
isolated communities because they had not been paid. With
most Russians facing a hungry winter, Prime Minister
Yevgeny Primakov appealed for foreign food aid.
Meanwhile, regional bosses fill the fiscal and power
vacuum, raising questions of whether the Russian
federation will break up, as the Soviet Union did in
1991. Governors of oblasts (states) hold back tax
transfers to Moscow, decree regional price controls and
manage their own foreign relations, forming partnerships
with local military commanders who ignore orders from
their nominal superiors. Analysts speak of
"semi-feudal principalities" forming around the
stronger oblasts and republics. The Cold War's
"balance of terror" between two nuclear-armed
superpowers is replaced by nuclear blackmail paid by the
outside world to maintain central authority over a huge
territory containing 30,000 warheads.
In both Russia and Brazil, foreign investors were tempted
foolishly by astronomical interest rates on government
debt, 120% in Russia and 43% in Brazil, each absorbing
the bulk of surging money flows to Eastern Europe and
Latin America in early 1998. "Greed prevails over
prudence," said former Fed chairman Paul Volcker.
Foreign banks accepted as collateral Russian government
bonds that went into default on August 17, the date of
Clinton's grand jury testimony in the Monica Lewinsky sex
scandal. Weeks before Russia's default big firms like
Goldman Sachs, Chase Manhattan, JP Morgan and Deutsche
Bank arranged $10 billion in government bonds and
syndicated loans for Russian companies that were
oversubscribed by banks, securities houses and hedge
funds, those curiously misnamed betting pools for big
investors, placing enormous bets that the ruble would be
stabilized by the IMF loan. Goldman used $550 million of
its own capital to pump up demand for the $1.25 billion
in Russian bonds it was promoting, part of the proceeds
going to repay its $250 million share of a bridge loan it
made earlier, then quickly sold off its own exposure
shortly before Russia's collapse, saying later that its
losses were "absolutely minimal." Panic spread
throughout the world after the IMF on July 20 withheld
$800 million of its initial $5.6 billion loan
disbursement because Russia failed to meet its fiscal
commitments. "Selling against Brazil commenced
immediately," according to Deutsche Bank.
International investors, many having borrowed heavily to
make their bets, lost $95 billion in emerging market
securities, according to JPMorgan, which in 10 days
recorded a 25% fall in its Emerging Market Bond Index.
Greenspan said Russia's default triggered a
"fundamental shift in attitudes...towards
risk-aversion pretty much throughout the world, as
exhibited mainly in the financial markets," creating
"a broad area of uncertainty or fear." The
circuits of the video game Money, Greed, Technology grew
so hot that the machine nearly exploded.
The explosion was threatened by failure in September 1998
of a hedge fund quaintly named Long-Term Capital
Management, driven by hyperactive traders, economists,
mathematicians and computers searching global financial
markets to find and bet, using borrowed funds, on market
correction of fleeting abnormalities in pricing bonds or
derivatives. Prodded by the Federal Reserve Bank of New
York, 15 banks, having lent $100 billion to the hedge
fund, poured another $3.6 billion into Long-Term Capital
to prevent more panic. This illustrated what Joseph
Schumpeter, in Business Cycles (1939), called "the
way in which financial facilities are provided for the
purposes of providing financial facilities, accomodation
for providing accomodation, [as] we move still further
away from the motor forces of our process."
Notable men ran Long-Term Capital as a partnership of
high-tech gamblers. Their leader was John Meriwether, who
was forced to resign as Salomon Brothers' vice chairman,
with the rest of top management, because Salomon hid a
1991 fraud in U.S. Treasury bond dealings. Heading the
Federal Reserve role in investigating the Salomon fraud
was David Mullins, a former Harvard Business Scbool
professor who resigned as Fed vice chairman in 1994 to
become a founding partner of Long-Term Capital. The hedge
fund's board was adorned by the intellectual authority of
Myron Scholes and Robert Merton, who shared the 1997
Nobel prize in economics for their work on derivatives.
As hedge funds are free of government regulation,
Long-Term Capital could use $2.2 billion in investors'
funds as collateral to buy $125 billion in securities and
pyramid this paper as collateral in exotic transactions
worth $1.25 trillion. After reaping profits exceeding 40%
in 1995-96, returns fell to 17% in 1997, with the start
of the Asia crisis. As the news worsened in 1998,
Long-Term Capital's capital withered from $4.8 billion in
January to $2.3 billion after Russia's default in August
to $200 million just before its bailout in late
September. After years of bowing to Long-Term Capital's
refusal to reveal its risk exposure, bankers in the
bailout, poring over the hedge fund's systems, learned
how outmoded its computer model was in being able to test
investment outcomes in rough markets.
Nobody knew the risks being run by financial
institutions. Noting "fragmentary"
information," the IMF surveyed a global total of
1,100 hedge funds with combined capital of $100 billion,
observing that "hedge fund capital pales in
comparison with capital of other institutional investors
[$20 trillion in mature markets]." George Soros, the
most famous hedge fund operator called the business
"a daisy chain with many intermediaries, and each
intermediary has an obligation to his counterparts
without knowing who else is involved." After losing
$2 billion on Russian bets, Soros shut down his Quantum
Emerging Markets Fund, which fell 31% in 1998 after
making huge profits in previous years.
Systemic problems came from the banks' mimicking of the
"risk management" strategies of the hedge funds
to which they lent indiscriminately. The risks became
clearer after Russia's default and the collapse of
Long-Term Capital. Union Bank of Switzerland, Europe's
biggest bank, declared a $684 million loss on its 15%
share in the hedge fund, which added to other losses of
major firms since Russia's default: Credit Suisse First
Boston ($400 million; Salomon Smith Barney, Nomura
Securities, Bankers Trust and BankAmerica (about $350
million each), and Merrill Lynch ($135 million). Other
big losers were Deutsche Bank, Dresdner Bank, JPMorgan,
Barclays, Bankers Trust and Bank Austria. Floating in
this stream of bad news was the discovery that Italy's
central bank invested $250 million in Long-Term Capital
before the hedge fund amassed a $49 million position in
Italian government bonds. "There is worse to
come," said an analyst in London. "We are going
to see a fairly steady stream of announcements, of
warnings, problems and retrenchments in coming
quarters."
Brazil then became what bankers called "the
firewall," the "line in the sand" to
defend against spreading financial contagion.
"Brazil is the linchpin of the world financial
system right now," said one investment strategist.
"No matter what happens, Brazil cannot go
down." Brazil's Ambassador in London told the BBC:
"This is Brazil's first crisis that is not our
fault." That is not quite true. President Fernando
Henrique Cardoso, his prestige enhanced by stopping
chronic inflation, missed two big chances to cut Brazil's
dependence on short-term inflows of foreign funds by
strengthening the country's public finances. The first
chance came when, after his landslide election victory in
October 1994, he waited six months before sending a
fiscal program to Congress, even though all of Latin
America was under financial pressure from the Mexico
crisis and Cardoso had just been Finance Minister for a
year, basing his Presidential candidacy on economic
stabilization. The second chance came in November 1997,
after a speculative attack on the Hong Kong dollar sowed
panic in financial markets around the world. To defend
Brazil's currency, Cardoso's economic team decreed big
increases in taxes and interest rates and big cuts in
public spending. Taxes and interest charges rose but
government spending did not fall. Public deficits rose
from 6.1% of GDP in 1997 to 7.8% in 1998. The Bank for
International Settlements (BIS) warned: "In the
absence of any improvement in the country's fiscal and
current account deficits, the unprecedented inflows of
banking funds to Brazil in the first quarter [1998] may
have raised the vulnerability of the country to an abrupt
reversal of market sentiment," as 64% of its foreign
bank debt at the end of 1997 was for less than a year.
The $37 billion in foreign investment from privatization
auctions in 1998 was nearly offset by panicked outflow of
$30 billion from Brazil in the weeks after Russia's
default. Brazil may finish the year with less than half
its peak hard currency reserves of $74 billion of April
1998. The amount of reserves usable in an emergency is
unknown because of secret future sales of dollars and
purchases of Brazil's own discounted debt by the Central
Bank and the Bank of Brazil. Under mounting pressure, the
government escalated its sale of short-term dollarized
public debt, payable in local currency at the going
exchange rate, with bonds akin to the tesobonos that
precipitated the December 1994 Mexican crash. Interest on
public debt now consumes 6% of GDP.
"For the past four years Brazil lived a fantasy of
monetary stabilization without pain," observed
Professor Celso Martone of the University of São Paulo.
"The Real Plan replaced inflationary finance of the
public deficit with foreign financing, fed by the
emerging markets boom. Worst of all, politicians and the
government came to believe in their own fantasy, with a
gigantic fiscal expansion. In 1998, the public sector is
spending at a historic record of 40% of GDP, despite
revenues also at a record high of 32% of GDP. Easy access
to international credit postponed the stabilization
crisis. With the Asian crisis, we are witnessing the end
of another international credit cycle like that of the
1970s."
Brazil was the big worry at the annual IMF-World Bank
meetings in Washington in October 1998. Panic spread
among bankers at luxurious receptions at hotels and
museums connected by limousine gridlock. A senior U.S.
monetary official told a big meeting of bankers that this
is the worst financial crisis since World War II, that
banks must lend regardless of risk and regulators must
relax prudential standards. "I woke up this morning
an optimistic man," said David Komansky, chairman of
Merrill Lynch, which had $1.4 billion of exposure to
Long-Term Capital and whose executives six months earlier
invested $22 million in the hedge fund in a deferred
compensation plan. "By the end of the day, I wanted
to jump out the window. What I've seen is fear and people
frightened. It's probably gone to a great extreme. But
people are concerned and frightened and that fear kind of
feeds on itself." To add to the consternation, on
the last day of the IMF-World Bank meetings, the dollar
fell to ¥112, nearly one-fourth below its August peak
against the yen. The panic was curbed by the second
quarter-point cut in interest rates by the Fed in two
weeks, giving stock markets an excuse to recover, as news
of plans for a $30 billion IMF-led bailout of Brazil
circulated in financial markets and Brazil's policymakers
leaked news of their latest emergency fiscal package.
When $23.5 billion in tax increases and spending cuts
finally were announced on October 28, financial markets
were skeptical that these measures would be passed by
Congress. Brazilian politicians reinforced this
skepticism with protests against new social security
taxes and restrictions on state and local government
spending. Brazil and several other stricken countries
face huge foreign debt payments during 1999 that are
unlikely to be refinanced in the climate of fear now
pervading financial markets.
The fear may be overdone. Yet the Asian crisis and its
repercussions elsewhere may be another episode in a shift
of power relationships not yet solidified nor clearly
understood. In the decade following the collapse of the
Soviet bloc we have seen eruption of local financial and
political disorders, until recently checked by the forces
engaged in the Cold War, that are multiplying too fast
for any single power or international bureaucracy to
manage or contain. The savagery that we have seen in
Somalia. Rwanda, the Sudan, the Congo, Algeria, Bosnia,
Albania, Kosovo, Afghanistan, the Ukraine, Azerbaijan,
Armenia, Georgia, Turkmenistan, Uzbekistan, Tajikistan,
Chechnya and Dagestan is not easily influenced by
trans-oceanic military or financial intervention. Western
oil companies are trying to make deals to build pipelines
across the dangerous southern fringe areas of the former
Soviet Union, along ancient trade routes, formerly known
as the Silk Road, that was secured first from endemic
banditry by Chinese armies some 2,100 years ago. In the
coming decade, interventions to contain local conflict
and disorder may be much more selective than in the
recent past and more closely aligned with specific
interests of the major powers. Priorities are being
sorted out as East Asia's troubles spawn small secondary
crises in Malaysia and Hong Kong and potentially bigger
ones in Indonesia, Russia and China. At issue is whether
Indonesia can remain a unified state, whether China can
peacefully accommodate market mechanisms and whether
Russia can overcome its historic ambivalence between
westernizing and autarchic/ autocratic cultures. The
contention between command and market economies has not
been decided. The resurgence of piracy, using speedboats
and modern weapons, in the South China Sea and the
Straits of Malacca recalls the endemic piracy in these
waters evoked by Herman Melville in Moby Dick (1851):
"Time out of mind the piratical proas of the Malays,
lurking among the low shaded coves and islets of Sumatra,
have sallied out upon the vessels sailing through the
straits, fiercely demanding tribute...." If
Indonesia, fractured into several island polities, proves
powerless to control this violence, then an arc of petty
states, some of them evolving into gangster satrapies,
will be forming along much of the southern tier of the
Eurasian land mass, breeding international conflict.
The kind of strategic shifts in power relationships and
trade that we see today are permanent features of the
world economy. Nearly three centuries ago Daniel Defoe
observed in The Complete English Tradesman (1726):
How frequent it is to hear an old tradesman say, Trade is
quite altered since I knew it; the methods are changed;
the manufactures are changed, the very places where they
are made are changed, the manufacturers remove from town
to town, and the places know them no more; the markets
remove where they are sold, and even the demands of them
both abroad and at home; the very nations, to which
particular goods were exported in former times, take none
of them now; and nations which formerly made no use of
them, are now the particular staple market for
them!....The various changes which trade has suffered,
may be attributed to the several turns given to the
manufactures by the invention of men; the violent
removings of the manufactures, and the markets of them,
from one city to another, and from one nation to another,
by wars; the convulsions of nations, the fall of old
empires and states, and the rise of new ones upon their
ruins.
Today what may be called normal shifts and turbulence in
the world economy are aggravated by heightened
proliferation of financial assets. Brazil, Russia and
many other national economies became dependent on
short-term flows of foreign capital. When the Dow Jones
industrial index peaked at 9,338 on July 17, 1998, half
of U.S. households owned stock, either individually or in
mutual funds, against only one-fourth during the 1987
Wall Street crash. In 1998 investors poured billions of
dollars into Internet stocks yet to show any profits.
Yahoo! Inc., with its internet search software, was
valued by the stock market at $9 billion, or 300 times
earnings. In An Essay on Projects (1697), Defoe wrote of
"fair pretences of fine discoveries, new inventions,
engines [that] have raised the fancies of credulous
people to such a height that, merely on the shadow of
expectation, they have formed companies, chose
committees, appointed officers, shares and books, raised
great stocks, and cried up an empty notion to that degree
that people have been betrayed to part with their money
for shares in a new nothing; and when the inventors have
carried on the jest till they have sold all their own
interest, they leave the cloud to vanish of
itself...."
While derivatives, overvalued currencies, real estate and
stocks and multiplication of short-term credit may fit
Defoe's description of "pretences" deceiving
credulous people, the financial turmoil that followed the
collapse of the Russian ruble in August 1998 has more to
do with institutional failure. The tension between market
and command economies is a major test of human
adaptation. For robust markets to prevail in contention
with command economies they must deal with overshooting
more effectively than they have so far in the Asian
crisis. With too much money chasing too few viable
business opportunities, the value of financial assets
must be scaled down to the real value of opportunities.
This means shrinking balance sheets and reducing debts to
realistic dimensions, giving shaky economies a viable
alternative to inflation, exchange controls and
protectionism.
While crashes may come from proliferation and overtrading
of financial assets in our time, we must remember that
capitalism has seen many financial crashes, but only one
Great Depression. The Depression was an especially severe
collapse of inflated asset values that damaged payments
systems and wrecked many kinds of economic activity. Most
politicians and economists of the day correctly believed
that the inflation of these asset values was a
consequence of World War I. The most important inflated
assets were Wall Street stocks, German war reparations
obligations and the British pound. The overvaluing of all
these assets was sustained by credit from the U.S.
financial system.
The Great Depression haunts us as no other event in
mankind's economic experience. Despite the turbulence of
recent months, there seems little risk today of Japan or
the United States or the world economy as a whole
suffering calamity on the scale endured in the 1930s.
From 1929 to 1933, the U.S. gross national product [GNP]
shrank by nearly half [46%] in current dollars or by 31%
in constant dollars after price declines of 22%. Nonfarm
employment also fell by 22%. The number of unemployed
multiplied eightfold, from 1.6 million in 1929 to 12.8
million in 1933, or from 3.2% to 25.2% of the civilian
labor force. The business failure rate rose by half.
Bankruptcy liabilities doubled by 1932. The prices of
farm products fell by half and industrial raw materials
by 23%. In early 1933 machine tool orders were 5% of
their 1929 level. In the oil patches of Texas and
Oklahoma, crude was selling for a nickel a barrel. The
price of wheat in 1932 was 38 cents a bushel, less than
one-third its 1926 level. Federal government revenues
fell by half, covering only 41% of spending in 1932,
creating a budget deficit of 4.7% of GNP, about the same
as the Reagan deficits of the 1980s. Big cities like New
York, Chicago, Philadelphia and Detroit went broke. The
financial problems of hundreds of states and
municipalities, plagued by tax shortfalls and collapsing
real estate values, fed into local economic crises that
led to 9,096 bank closings in 1930-33. Among industrial
countries, the U.S. and Germany suffered most because
they spawned the biggest credit expansions that were very
vulnerable to economic contraction. Britain, France and
Japan suffered less because Britain was stagnant
throughout the 1920s, France was running a tight ship
after a 1926 stabilization crisis and Japan was
recovering from a 1927 banking panic that purged
speculative fever enough for Japan to expand again in the
1930s.
Looking backward over the past 120 years, despite
episodic setbacks in individual nations and groups of
countries, the only big output losses for the world
economy as a whole came from wars. In 1945-46 the fall in
production was bigger [18%] than in 1930-33 [17%].
According to Angus Maddison, a leading analyst of
long-term trends in the world economy: "The
aggregate stability in the collective output in peacetime
has been quite impressive." In the 43 years from
1870 to 1913, there were only two years [1893 & 1908]
of output loss for the advanced countries, the only
long-term statistical proxy available for the world
economy as a whole, and since 1947 only two more years
[1975 & 1982]. Smoothing of business cycles persisted
despite stock market crashes and bank crises in 1968,
1970, 1973-74, 1982-84 and the 1990s. History is on our
side, unless we go to great lengths to foul things up and
ignore obvious dangers.
In his book, The Crash and Its Aftermath, Barrie A.
Wigmore, a Goldman Sachs partner, spelled out one of the
main lessons of the Great Depression: "Lenders were
unwilling to adjust the debts due to them for the severe
price level changes, and interest rates could not be said
to have declined at all. Creditors accordingly had to
bear debt burdens much greater in real terms than they
bargained for. In the real estate, farm and commodities
businesses, these debt burdens bankrupted the debtors.
Thus, the financial system stuck to its practices as
price levels changed, and the economy was required to
adapt." In Latin America's debt crisis of the 1980s,
readjustment of obligations came only after a decade of
recrimination and delay as well as relaxation of monetary
policy in the United States and Japan. After that, the
$156 billion in outstanding Brady debt-reduction bonds
became one of the hottest items in securities trading,
with a 1996 turnover of $2.7 trillion, or 17 times face
value. With this experience under their belts, the
enhanced creativity of investment banks and hyperactive
traders may find profitable opportunities in bringing to
life more comforting scenarios than the ones currently
programmed in the video game Money, Greed, Technology.
The recent economic trouble in Russia, Brazil, Japan,
Indonesia, Venezuela, Korea, China, Malaysia and Hong
Kong dramatizes unsuspected difficulties embedded in
reform programs inspired by economists and politicians
outside the countries where reform is supposed to take
place. Unrealistic expectations were awakened by giant
financial rescue packages negotiated by the IMF. We do
not know if the technological and entrepreneurial power
of globalization will advance or recede in conflict with
local institutional and political obstructions.
Market-oriented reforms succeeded in intensifying
economic activity and raising living standards Latin
American countries racked by chronic inflation and in
East European states reorganizing their politics and
economies after the collapse of the Soviet bloc, but
faltered when entrenched interests in other countries
faced less desperate challenges. After the resignation of
President Suharto, Indonesia faces economic shrinkage for
1998 of 13%-20%, with riots, food shortages, massive
unemployment, bank failures and default on its foreign
debt. In East Asia, soup kitchens and rice lines are
appearing. Boulevards and parks are being occupied by
squatters as people are evicted from their homes for
non-payment of rent. Output is falling by 6%-7% in Korea
and Thailand, 4% in Hong Kong and 2% in Malaysia,
according to projections by their respective governments,
with private estimates of losses running much higher.
The Asian crisis shows us that changes must be made in
the international financial system to better manage the
multiplication and diversification of assets. There are
no magic or permanent formulae for doing so. Only blunt
instruments can contain collective madness in
international financial markets. Each specific and
meaningful proposal to regulate and restrict excesses of
volatility and promiscuity will generate controversy,
costs and limited effects. However, a battery of
thoughtful measures together might reduce the waste and
dangers bred by unbridled proliferation of financial
assets. Useful steps, to be taken by agreement among the
member central banks of the BIS, might include
initiatives like these:
1. Limit short-term lending to a certain percentage,
fixed by the BIS, of foreign assets of lending countries
and foreign liabilities of borrowing countries, making
allowance for normal provision of trade credits.
2. Limit leveraged trading of financial assets by banking
institutions.
3. Eliminate offshore financial centers by international
agreement, with the United States and Britain taking the
lead in refusing to enforce contracts registered in these
jurisdictions.
4. Restrict sales and trading of derivatives to public
futures exchanges where contracts are registered, records
of large positions are kept and prices published under
regulated capital-adequacy provisions. Banks and other
financial institutions should be required to allocate
capital to support derivatives bets, with courts
assigning them the same legal status as gambling debts.
5. Banks should not be allowed by regulators to supervise
their own risk profile with "risk control"
software, which can generate dangerous macroeconomic
effects by failing to anticipate political and credit
risk as well as random events.
In the end, if Santa Claus is dead, assuming that he ever
lived, then countries must solve their own problems. In
the challenge facing Brazil and the stricken East Asian
countries, this means pursuing modernization of
institutions to achieve more efficient use of capital and
to reduce dependence on episodic floods of short-term
money issuing from the worldwide proliferation of
financial assets subject to severe and sudden
interruptions. The Asian crisis has shown both the
strength and limitations of the international system.
Never before have debtor countries received so much
support so fast from foreign governments and
international institutions. This story is not over and
troubles are sure to come. These countries' basic
institutional problems are not amenable to short-term
solutions, but a start has been made. What will decide
their future is their capacity to respond to shocks and
to adapt to changing conditions of economic life.
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U.S. AND WORLD ECONOMY