Why did Asia crash?

[Dennis L. Fiddle]

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[Economics Focus]
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Why did Asia crash?
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Disaster has spawned a new theory of financial crises
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LESS than two months ago, Bill Clinton dismissed Asiaąs currency
turmoil as ła few little glitches in the road˛. Today, no one is
so sanguine. The collapse in asset prices, the extent of
financial and corporate insolvency and the slowdown in economic
growth across the region are much worse than expected.
Economists, like everybody else, are scrambling to understand
why.
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The most popular explanation is that these countries are facing
currency crises. Thailand was forced to abandon its peg to the
dollar in July 1997 after a sustained speculative attack. Others
faced the same fate after their currencies became relatively
less competitive. Unfortunately, this reasoning does not explain
why South Korea, an economy wholly different from others in East
Asia, landed in such trouble. Nor does it explain why Asiaąs
currencies were subject to attacks in the first place.
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Conventional economic wisdom suggests two possible causes of a
currency crisis. The first is government profligacy. If a
country with a pegged exchange rate prints money to cover a
budget deficit, investors will prefer to hold a less
inflation-prone foreign currency, and foreign-exchange reserves
will fall. At some point, speculators may assume that the
country will no longer be able to defend its exchange rate and
will attack the currency. This explanation does not fit Asia,
where budgets are more or less in balance.
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Currency crises might also occur because pegging the exchange
rate requires governments to use monetary policy in order to
maintain the currencyąs value. But as raising interest rates to
protect the currency means slowing the economy, a government
might at some point decide that the pain of maintaining the
fixed exchange rate is not worthwhile. If the market doubts the
governmentąs commitment, then it will attack the currency.
Again, this explanation does not fit Asia.
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Diverse as they are, the East Asian countries have two
characteristics in common. Throughout the region a boom-bust
cycle in asset prices preceded the currency crisis. And in each
case, banks and finance companies that lent on overly risky
projects lie at the heart of the problem. In an intriguing new
paper* Paul Krugman of the Massachusetts Institute of Technology
shows how these ingredients might suddenly precipitate a crash.
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Mr Krugman, who pioneered formal economic analysis of what
causes currency crises, points out that Asiaąs banks and finance
companies operated with implicit government guarantees. These,
together with poor regulation, distorted investment decisions,
encouraging bankers to finance risky projects in the expectation
that they would enjoy the profits, if any, while the government
would cover serious losses.
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Competition among over-guaranteed and under-regulated banks
leads bankers to base decisions not on a projectąs expected
return but on its return in ideal circumstances, or what Mr
Krugman calls its łPangloss˛ value. Two implications follow:
there will be too much investment, and the price of assets that
are in limited supply, such as land, will rise excessively. He
gives the following example. The rent on a plot of land has a
2/3 probability of being $25 and a 1/3 probability of being
$100. A risk-neutral investor would pay $50 for the plot (2/3
times $25 plus 1/3 times $100). But the guaranteed bank would be
willing to lend up to the łPangloss˛ value of $100. Eventually,
asset prices would be twice their values in an undistorted
market.
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This bubble persists so long as the government guarantee is
maintained. But then reality strikes. The first banks whose
investments fail to yield Pangloss returns get bailed out, but
the cost of the bail-outs reduces governmentsą willingness to
provide future rescues. Without those implicit government
guarantees, Pangloss values collapse, leading to a general fall
in asset prices, which in turn, leads to loan defaults and
losses for the banks. This starts a spiral in which pessimism
become self-fulfilling.
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Mr Krugmanąs theory is illuminating, particularly in explaining
why the crisis has been so severe despite the absence of big
economic shocks. Like any model, this one simplifies reality. In
the real world, bankers must put their own capital at risk, and
governments do not cover all losses. Much investment is
undertaken by private citizens and foreign banks who do not
expect to be bailed out. Mr Krugmanąs model does not distinguish
between domestic and foreign creditors‹a significant omission,
given that East Asiaąs problems grew because foreign banks kept
lending even after signs of crisis became apparent (see charts).

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Nonetheless, the model suggests intriguing conclusions. First,
Asiaąs real problem lies with banks and their regulation.
Second, international capital mobility may not always maximise
economic efficiency if banks are over-guaranteed and
under-regulated. If foreign capital did not flow freely,
Pangloss investment would push up domestic interest rates and
slow the investment boom. Access to foreign capital weakens this
restraint, allowing the bubble to get larger.
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Third, Mr Krugmanąs analysis weakens the rationale for the IMF
and foreign governments to bail out troubled economies. The
support is meant to restore investorsą confidence and limit
economic collapse. But to the extent that these economies were
living on a bubble, collapse is inevitable. Until it has run its
course, restoring confidence may not be possible.
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* łWhat happened to Asia?˛ Available on-line at
http://web.mit.edu/krugman/www/DISINTER.html, which is Mr
Krugmanąs website. January 1998.

source http://www.economist.com/editorial/freeforall/current/fn7075.html

--
dfi...@mn.uswest.net (Dennis L. Fiddle)
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