Asia: What Went Wrong
(FORTUNE Magazine) – There is a part of me that is excited, even happy, about Asia's financial crisis. You see, financial disasters are one of my specialties. The very first serious economics paper I ever wrote, more than 20 years ago, was titled "A model of balance-of-payments crises." And so I am a bit like a tornado-chaser who has just caught up with a monster twister. I'm as sorry as anyone about those poor people in the trailer park, but I am also more than a bit thrilled to have the chance to watch this amazing spectacle unfold. I can even offer an excuse for my mixed feelings: You learn a lot more about how the global economy works when something goes wrong than when everything hums along smoothly. And maybe the lessons we learn from this crisis will help us avoid, or at least cope better, with the next one.
So what have we learned from Asia's mess? Speculative attacks on currencies are nothing new, and some of us even warned a couple of years ago that Southeast Asian countries might be at risk. But the scale and depth of this crisis have surprised everyone; this disaster has demonstrated that there are financial dangers undreamt of in our previous philosophy.
By now we have a pretty good idea of what happened to Asia. Think of it, so far, as a play in two acts, the first about reckless behavior and the second about its consequences. What nobody knows yet is how close we are to the end. Is the play almost over, or is there a tragic final act still to follow?
The first act was the story of the bubble. It began, we now think, with bad banking. In all of the countries that are currently in crisis, there was a fuzzy line at best between what was public and what was private; the minister's nephew or the president's son could open a bank and raise money both from the domestic populace and from foreign lenders, with everyone believing that their money was safe because official connections stood behind the institution. Government guarantees on bank deposits are standard practice throughout the world, but normally these guarantees come with strings attached. The owners of banks have to meet capital requirements (that is, put a lot of their own money at risk), restrict themselves to prudent investments, and so on. In Asian countries, however, too many people seem to have been granted privilege without responsibility, allowing them to play a game of "heads I win, tails somebody else loses." And the loans financed highly speculative real estate ventures and wildly overambitious corporate expansions.
The bubble was inflated still further by credulous foreign investors, who were all too eager to put money into faraway countries about which they knew nothing (except that they were thriving). It was also, for a while, self-sustaining: All those irresponsible loans created a boom in real estate and stock markets, which made the balance sheets of banks and their clients look much healthier than they were.
Soon enough, Asia was set up for the second act, the bursting of the bubble. The bursting had to happen sooner or later. At some point it was going to become clear that the Panglossian values Asian markets had placed on assets
weren't realistic in this imperfect world, that Asian conglomerates are no better than their Western counterparts at trying to be in every business in every country. But the collapse came sooner rather than later because speculative bubbles are vulnerable to self-fulfilling pessimism: As soon as a significant number of investors begin to wonder whether the bubble will burst, it does.
So Asia went into a downward spiral. As nervous investors began to pull their money out of banks, asset prices plunged. As asset prices fell, it became increasingly doubtful whether governments would really stand behind the deposits and loans that remained, and investors fled all the faster. Foreign investors stampeded for the exits, forcing currency devaluations, which worsened the crisis still more as banks and companies found themselves with assets in devalued baht or rupiah, but with liabilities in lamentably solid dollars.
What actually started this downward spiral? Who cares! Any little thing can set off an avalanche once the conditions are right. Probably the proximate causes were a slump in the semiconductor market and a rise in the dollar-yen exchange rate, but if they hadn't triggered the crisis, something else would have.
Asia's financial implosion is, of course, dragging the real economies down with it. Partly, that is because the collapse of asset values is making people feel poorer, depressing consumer demand; partly it is because low stock prices and high interest rates are depressing investment. But there is also--disturbingly--a supply-side effect. Although runaway banks were the original source of the mess, a functioning banking system remains a crucial lubricant for the economic engine. With banking in some Asian countries effectively paralyzed, that engine is showing signs of seizing up: even companies that should be profitable--like exporters--are finding themselves hamstrung by lack of credit. It is, in short, a terrible but also fascinating spectacle.
Could it get worse? If there is a third act, it will involve the interaction of economics and politics: economic crisis will lead to political instability, instability will lead to capital flight that reinforces the economic crisis, and all heck will break loose. But so far only Indonesia shows even faint signs of such a new vicious circle, and even there most sensible observers think that the risks of really serious unrest have been exaggerated.
I hope they are right. For economic tornado-chasers, Asia's disaster may have been a perfect storm. But anyone who cares seriously about the real people whose livelihoods--and, in some cases, lives--are now at risk can only hope that the storm will soon be over.
PAUL KRUGMAN is a professor of economics at the Massachusetts Institute of Technology.