Commentary Type

Global Aftershocks: Lessons from Asia/Russia/Brazil

Paper for the San Francisco Committee on Foreign Relations


Financial shocks are a fact of capitalist life, but the virus mutates!

  • In the "old days", financial shocks were connected with real investment booms and busts (railways, electric power, autos…), leading to inflation, then tight money.

  • In the 1970s and 1980s, financial shocks in emerging countries were connected with large fiscal deficits, high inflation, and big trade deficits.

  • In recent episodes-US (late 1980s, and late 1920s!), Mexico (1994/95), Asia (1997/98), Russia (1998), Brazil (1998/99)-financial shocks were connected to bad banking, pegged exchange rates, high debt/equity ratios, fraudulent accounting.

Same economic medicine, different timing

  • Treatment 1: Cut the fiscal deficit, devalue the currency, raise interest rates, reschedule loans, provide fresh capital to core borrowers.

  • Treatment 2: Modestly boost public spending, cut interest rates.

  • Treatment 3: Enhance surveillance/regulation of financial sector and accounting practices (SEC, IOSCO, BIS, …)

Recovery speed depends on patient's prior condition and environment

  • Early indices of recovery: stock market rebound; narrowing interest rate spreads (low quality vs. high quality); disinflation; reduced trade deficit (collapsing imports).

  • Later indices: exports grow; GDP stops falling and begins to recover; corporate profits reappear.

  • If the economy is flexible (mobile labor and agile corporations), if financial institutions are quickly restructured, and if political institutions are stable, the recovery is faster. Latin America of the 1980s vs. Mexico of the 1990s.

  • If the external economic environment is strong, the recovery is faster. Compare the industrial nations of the 1920s vs. Mexico and Brazil of the 1990s. Compare the context of the small Former Soviet Union states with the context of Southeast Asia.

Contagion strikes the weak, not everyone!

  • Financial contagion is not like the Black Plague of the Middle Ages or the great influenza epidemic of 1918, striking young and old, weak and strong. It is like the virulent tuberculosis in today's hospitals, claiming those already weakened. Compare Taiwan and Korea; Baltic countries vs. Russia; Argentina and Mexico vs. Brazil; Australia and New Zealand vs. Southeast Asia.

  • In a flexible world economy, the adverse trade impact of a shock in sick country X can be mitigated in healthy country Y through appropriate monetary policy (lower interest rates), taking advantage of lower world prices. The US, Canada, Australia and indeed China have weathered the storm. The "cost" however is large trade deficits (or smaller trade surpluses): the US trade deficit in 1999 will exceed $300 billion; China will have a zero trade surplus, down from $50 billion in 1997.

Perfect vaccines don't exist, but modest precautions do

  • Wall Street-in all its manifestations-will drive the global economy of the 21st century. Tailor the remedies accordingly.

  • Moral hazard: increase the risk exposure of banks and bondholders. Compare the bailout of Korea with the current debate over Pakistan.

  • Provide incentives for sound banking, strict accounting, financial "transparency".

  • Stay away from "soft" currency pegs: embrace "hard" pegs or free floats.

  • Focus the IMF on core macroeconomics (fiscal deficits; monetary policy; exchange rate policy) and financial surveillance.

  • Shift the IMF action agenda from emergency room care to public health prevention (via access to credit and interest rates charged).

  • Avoid the panacea of capital controls; adopt the complementary features of Anglo-Saxon capitalism-hostile takeovers and bankruptcy.

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