New York Times February 17, 1999

World's Markets, None of Them an Island

By NICHOLAS D. KRISTOF with SHERYL WuDUNN

In Red Square, just across from the mausoleum where Lenin lies in state like some old biological curiosity preserved in formaldehyde, there is a grand three-story stone building that these days is in about the same shape.

The rococo facade of the GUM department store resembles that of a cathedral, but its gaudy interior is an emporium with mink coats on hangers and on customers. GUM seemed a symbol of Russia's hope, for the spiffily dressed chairman of the board, Yuri Solomatin, 44, came across as a Russian capitalist with a difference.

Solomatin eschewed the mob, limousines and bodyguards; he did not wear fat diamonds on his fingers or endless-legged women on his elbow; and he boasted of running the most open, market-oriented, Western-style company in all Russia -- proving this by granting himself and other managers stock options that soared fifteenfold. He sold more than half of GUM's stock to foreigners, mostly Americans and Europeans, an unheard-of feat in nationalistic Russia.

Then came the Russian devaluation and market meltdown in August, and suddenly GUM crumbled. Its stock has fallen to 25 cents a share, from a peak of $5.40, and its shops today are a sea of signs that scream "skidka" -- discount.

"Overnight," Solomatin said heavily, sitting in a third-floor conference room, "we were made paupers."

How did GUM get hit by what started as a run on the Thai currency in July 1997? Why did the crisis ripple from country to country and end up leaving Russia facing hunger and economic chaos, with 30 percent of Russians living below the poverty line, up from 18 percent at the end of 1996? And why has it now hit Brazil and shaken financial markets in Argentina, Colombia and Mexico?

The answers will be hotly debated for years, but some tentative explanations are emerging for what is known as the contagion effect: the tendency of a financial crisis to spread and "infect" other nations.

The growing interdependence through the fabric of the world economy connected GUM even to Mary Jo Paoni, a secretary in Cantrall, Ill. Mrs. Paoni patronizes a Bergners department store, and her husband frequents Kmart, but through her Illinois state pension fund she was in a sense a tiny part owner of GUM.

The pension fund owned $7.2 million worth of the Brinson Emerging Markets Fund, and records show that Brinson in turn bought $138,000 in GUM stock.

Mrs. Paoni was linked to GUM in another way, for her pension fund has $1-million worth of shares in Germany's Dresdner Bank. And Dresdner, excited by GUM's prospects, lent it $10 million.

In the Soviet days, GUM was the best department store in the country, with lines of people waiting each morning to enter, and it set aside a special area on the third floor, Section 100, where ordinary shoppers were banned and top Communist Party officials could pick up fine clothing unavailable anywhere else in Russia.

Partly because of its fame, GUM was among the first Russian companies to be privatized after the fall of the Soviet Union. It became an upscale shopping mall, and every day 200,000 shoppers trooped down its aisles.

More than 40 international retailers occupied space, paying what analysts said were higher rents than anywhere else in Europe. Samsonite reported that it sold more per square foot in its luggage store in GUM than in any of its other outlets around the world.

Over all in GUM, sales soared to an average of $926 per square foot, one of the highest such figures in the world. In contrast, Bloomingdale's in New York says that its sales are $267 per square foot.

Fund managers were impressed by all this and by GUM's declared commitment to international standards. It even put out annual reports in English as well as Russian.

"GUM has a strong balance sheet, no long-term debt and high liquidity," wrote Sector Capital, a Moscow investment bank, in 1996. "The company is very profitable, with a 40 percent return on assets. Together with the company's financial stability, this makes GUM a very attractive investment."

In retrospect, GUM and its American owners made the same kind of mistake as the Thai real estate developers who started the whole mess. They became so accustomed to the long summer days that they came to disbelieve in winter.

When Thailand floated its currency on July 2, 1997, the date that is now regarded as the beginning of the global financial crisis, the only shudder passing through GUM was one of delight -- at its rising stock price. Over the next three months, the stock rose 37 percent, to a new peak.

Devalued and Misdiagnosed

Nobody else was initially very worried that Thailand's problems would radiate around the world. While some of Thailand's underlying problems were well known, on the day of the devaluation the Thai stock market rose 7.9 percent, its biggest gain in more than five years.

In hindsight, absolutely everyone seems to have made a catastrophic misdiagnosis of the problem, one that resulted in Thailand's getting insufficient treatment and in exposing other countries to the contagion. The misdiagnosis was twofold: first, that Thailand probably faced a typical temporary downturn, rather than a staggering depression that would last for years; second, that the problem was largely confined to Thailand rather than the beginnings of a serious global crisis.

The Clinton administration initially saw the crisis as a replay of what had happened in Mexico in 1995, and prescribed the same mix of austerity and aid. So in the late summer of 1997, Treasury Secretary Robert Rubin and his deputy, Lawrence Summers, signed on to a standard International Monetary Fund plan: spending cuts, high interest rates and a repair job on the Thai banking system. But over the protests of the fund, the United States declined to contribute to a bailout.

Rubin and Summers were adamant that they could not contribute because of congressionally imposed restrictions. The State and Defense Departments were unhappy with Treasury's tightfistedness, but Treasury officials suggested sarcastically if any other department had a spare billion or two in its budget and wanted to help the Thais, it should feel free to do so.

Rubin still insists that he made the right economic decision, but he seems less sure that he got the diplomacy right.

"I don't think it would have made a difference economically," he said of a contribution to Thailand. "Diplomatically, I don't know."

A senior State Department official said flatly: "In hindsight, it was a mistake."

Thailand appealed to Japan for financial help that summer of 1997, and officials in Tokyo say they thought seriously about arranging a big package of loans. But in the end they did not, partly because Washington insisted that a rescue be made only through the monetary fund and only after imposing tough conditions on Thailand.

With the firm backing of Treasury, the fund initially forced Thailand to accept austerity, including budget cuts and high interest rates. The idea was that sky-high interest rates would attract capital back to Thailand and stabilize exchange rates, but they also ended up devastating otherwise viable businesses. Many economists, including those at the World Bank, have criticized the fund's approach as initially worsening Asia's problems, and even the fund has admitted that its budget cuts were too harsh.

By early 1998, recognizing that the slump was unexpectedly serious and that the initial conditions had been too tough, the fund and Treasury reversed course. They steadily allowed Thailand to reverse planned budget cuts and to ease the austerity, but the damage had been done.

Rubin stood his ground, saying that the higher rates were needed to stabilize currencies in Thailand and South Korea, laying the groundwork for eventual recovery.

The alternative is "likely very chaotic conditions, far greater inflation and a risk that confidence will not come back for a recovery," he said. Countries like Indonesia that resisted the fund's medicine ended up even worse off, he notes.

After initially bowing to Washington's desires and declining to rescue Thailand directly, Japan became more assertive as it saw the crisis worsen. In September 1997, Japanese officials proposed a $100-billion bailout plan called the Asian Monetary Fund, to be paid for half by Japan and half by other Asian countries.

This would not have cost the United States a penny, but Rubin was furious about it, partly because the Japanese had not consulted him. He fumed as he strolled about the Air Force jet carrying him to the annual meetings of the fund and World Bank in Hong Kong.

Rubin, who has often shown a deep distrust and distaste for Japanese officials, gathered with Summers and other aides in the forward compartment of the plane to plot strategy. As the group nibbled on nachos, Rubin complained that the proposal would undercut American interests and influence in Asia, and that Japan would lend the money without insisting on tough economic reforms.

Rubin and Summers succeeded in killing the plan, with the help of Europe and China. Many in Asia now regard that as a crucial missed chance, and there is real bitterness that the United States had muscled in to prevent Japan's attempted rescue of its neighbors.

Treasury officials stand by their opposition to the Asian Monetary Fund, saying that the plan would not have changed anything, for it would have taken time to implement and, as Japanese officials later acknowledged, Japan was itself hard up for cash.

"The Japanese plan was vapor," a Rubin associate said recently. "It wasn't going to happen. It was ill thought out."

Yet some other American officials now say, a bit sheepishly, that if they had realized the seriousness of the crisis, they might have been more accepting of the proposal. In November 1998, a year after Washington killed the plan, Japan came back with another one, on a smaller scale. Instead of trying to subvert it, Rubin now called the idea constructive. President Clinton hailed it as one of Japan's "important contributions to regional stabilization."

World's Markets, None of Them an Island

(Part II)

Herds Pick Up a Scent

Treasury opposed the first Japanese fund in part because it -- along with everybody else, including investors, scholars and journalists -- thought that the storm over Asia would probably pass. Yet something fundamental had changed. Perceptions of risk had altered, and people began to get nervous about holding any Asian currency.

The anxieties became self-fulfilling, particularly as Thailand's economy began to self-destruct. Speculators, stock investors and local businessmen alike wanted the safety of dollars, and during the fall of 1997 currencies fell in the Philippines, Malaysia, Indonesia, Taiwan and South Korea.

Since many Asian countries had problems with heavily indebted corporations, inflated stock and property prices, overvalued currencies, and bad loans, it was easy to find similarities to Thailand once people began to look. Just as Western capital had flooded into emerging markets as a group in the early and mid-1990s, now it began to ebb.

Take Barton Biggs, the strategist at Morgan Stanley, who, a few years earlier, had helped ignite the Asian investment boom. As Thailand began to fall apart in the fall of 1997, he made another trip to Bangkok, and this time his advice was grim.

"I really went with the idea that Asia was sold out and bombed out and that there must be some attractive values," he said in a teleconference with investors on Oct. 27, 1997, recorded by Bloomberg. "And I've got to say that I was disappointed."

Biggs told investors to sell all their holdings in markets like Hong Kong, Singapore and Malaysia, and to cut by one-third their investments in emerging markets like Thailand and Indonesia.

No Banks in Casualty Ward

The dominoes began to fall. In late October 1997, right after Biggs' announcement and partly because of it, the Hong Kong stock market plunged 23 percent over four days. The debacle in Hong Kong suddenly caught Wall Street's attention, and in New York on Oct. 27, the Dow Jones Industrial Average tumbled 554 points, its biggest one-day point loss in history.

"That changed everyone's calculations," recalled Stanley Fischer, the fund's deputy chief. Suddenly, contagion was the buzzword, and there were regular meetings on the crisis in the Situation Room at the White House. Yet while White House officials pondered what to do, investors were busy selling. Anything that seemed to hint of emerging markets was dumped, and stock markets in Brazil, Argentina and Mexico also suffered their worst one-day losses ever.

Mrs. Paoni's money in the Illinois pension fund joined the rush to the exits. Records show that the fund managers sold Indonesian stocks that had cost them $3.3 million, Malaysian stocks that had cost $1.9 million, Philippine stocks that had cost $1.5 million, South Korean stocks that had cost $1.1 million, and Thai stocks that had cost $2.2 million. Across the world, everybody was doing the same.

Soon Indonesia was forced to accept a $17-billion bailout, later raised to $23 billion, to which the United States agreed to contribute -- an implicit admission that it had made the wrong call with Thailand. Pressure grew on South Korea, Taiwan, Malaysia, Brazil, Russia and other countries. Everybody seemed alarmed except Clinton, who in November 1997 tried to sound reassuring.

"We have a few little glitches in the road here," he said. "We're working through them."

Clinton was perhaps listening too closely to the State Department, for American diplomats in Bangkok were sending out rosy cables, and their counterparts in South Korea were similarly oblivious to the Korean economy's disintegration, which was then well under way. In Washington, Rubin and Summers had a far clearer sense of what was happening in South Korea, and were openly disparaging of the diplomatic reports from the field.

The State Department missed its cues because, historically, it had focused on the threats from Communists who carry grenades, not on the threats from business executives who wear neckties and trade currencies. The same was true of the Central Intelligence Agency, which proved itself, in the words of one of its top officials, "completely unprepared to deal with questions of an economic nature."

Yet by Thanksgiving Day 1997, it was clear to all top officials in Washington that South Korea was on the brink of an economic catastrophe. After five hours of conference calls among top American officials, Clinton telephoned President Kim Young-sam of South Korea and told him he had no choice but to accept an international bailout.

Kim bowed to the inevitable and accepted a bailout that swelled to $57 billion, the biggest ever. But with that money now flowing into South Korea, Western banks saw a chance to take it and run. The banks called in their loans, hoping to flee while they could.

Rubin quietly called the heads of major banks and urged them to reschedule their loans, and in the end they did.

But the bailout still ended up bolstering Western banks. South Koreans lost their businesses and in some cases were even driven to suicide. But foreign banks -- among them Citibank, J.P. Morgan, Chase Manhattan, BankAmerica and Bankers Trust -- were rewarded with sharply higher interest rates (2 to 3 percentage points higher than the London interbank rate) and a government guarantee that passed the risk of default from their shareholders to Korean taxpayers. The banks say that this was only fair, because they were extending their loans up to three years and thus assuming an extra burden.

Yet in contrast to previous financial crises, which were resolved by banks' effectively paying a good share of the bill, this was a huge bailout with public funds, and the banks did not chip in major new money.

Rubin defends the bailouts, saying that he "wouldn't spend a nickel" to bail out banks or investors, but that helping the country often means ensuring that it can pay off its creditors.

But critics note that the some of the biggest beneficiaries are the banks. "The effort is hurting the countries they are lending to, and benefiting the foreigners who lent to them," argued Milton Friedman, the Stanford University economist and Nobel Prize winner. Friedman argues that the monetary fund does more harm than good and is bitterly critical of these bailouts.

"The United States does give foreign aid," he said. "But this is a different kind of foreign aid. It only goes through countries like Thailand to Bankers Trust."

Smart Set, Foolish Choices

With the collapse of South Korea, investors rushed from any sign of risk. At Morgan Stanley, Biggs had bought emerging markets early in 1997 for his own portfolio, but now he sold frantically. Records at the Securities and Exchange Commission show that in December 1997 he sold $56,000 worth of his own company's Malaysian Fund, $650,000 worth of Emerging Markets Fund, $80,000 worth of India Investment Fund, $137,000 in the Pakistan Investment Fund and almost $1.6 million worth of Asia Pacific Fund.

Tens of thousands of other investors were doing likewise, liquidating their holdings in emerging-markets funds. This created another kind of contagion. Sales of emerging-markets mutual funds forced fund managers to pare down their portfolios to pay back shareholders. This meant that fund managers had to trim holdings even in distant countries, even in stocks that they regarded as still valuable. In this way the electronic herd rushing away from Korea ended up trampling stocks in Argentina and Mexico.

The world seemed to be coming apart, and so was the U.S. government's consensus on what to do.

Indonesia was particularly nettlesome because of the question of how to treat President Suharto, the aging dictator, whom Clinton had previously supported.

While on a trip to Texas on Jan. 8, 1998, Clinton telephoned Suharto from Air Force One to urge compliance with the monetary fund program. But Suharto stuck to some of his ideas about how to run the economy, like a "currency board" to back Indonesian money with dollars.

A White House aide recalls Suharto's growling, "Look, I understand that this doesn't cure anything, but the IMF isn't curing anything either."

American officials were puzzled about what to do, and they had no intuitive feel for what might happen next.

"The nature of the crisis was not understood," recalls a senior official who weathered the thick of the crisis. "We didn't really grasp everything that was going on."

Nation's Drive-By Shooting

Indonesia has been hit hardest, but what remains unclear is whether it had to suffer at all. Some economists argue that Indonesia was simply the victim of the international equivalent of a drive-by shooting.

Its trade balance was in relatively healthy shape. It had a respectable $20 billion in foreign exchange reserves and did not squander them trying to defend its currency. Credit had grown more slowly than in other countries, and there was less indication of a bubble. The government initially reacted with foresight, going to the fund before any severe problems developed.

Yet in the end the Indonesian currency lost 85 percent of its value, riots cost more than 1,000 lives and hunger became widespread. Today there are doubts about whether Indonesia can survive as a nation; some fear that it will fragment like Yugoslavia.

"These horrendous things did not have to happen," argues Jeffrey Sachs, a Harvard economist, who blames the United States and the monetary fund for deepening a financial panic. "The crisis was pushed to an extreme that it never had to take."

Indonesia was particularly vulnerable to panic because most of its private wealth is in the hands of ethnic Chinese who are unusually likely to seek safe havens for themselves and their money. Public confidence was therefore Indonesia's most precious commodity, but it dissipated as officials from Washington tangled repeatedly with the Indonesian government over how to deal with the crisis.

Suharto's handling of it was disastrous. He backtracked on closing banks, adding to confusion, and resisted many reforms that would have threatened his family empire. The fund forced Indonesia to close 16 banks, but then in an internal document acknowledged that it had gravely erred and that the closures had triggered bank runs around the country.

Both Treasury and the fund ridiculed Suharto's budget proposal, which because of exchange-rate movements showed a 32 percent spending increase in local currency terms. But three weeks later, having already irreparably harmed Indonesia's image, the fund quietly approved a budget with a 46 percent spending increase.

Woes Dervied but Undiluted

As currencies and countries tumbled, another form of contagion began to take a toll on world economies: financial derivatives.

Originally called synthetic securities, derivatives are so named because they are derived from something else -- an underlying stock or bond. They can be as simple as an option to buy a stock, or they can be complex products involving multiple currencies, loans and bonds. In effect they are repackaged securities, stuck together like a complex work of financial Lego.

There is nothing inherently harmful about derivatives, and they can be very useful to protect against risks. But they can also be used to speculate. Their tremendous variety is reflected in the nicknames given to various kinds: the jellyroll; the iron butterfly; the condor; the knockout option; the total return swap; the Asian option.

These are jellyrolls that really sell. Western sales teams were active in Asia, and they often peddled complex financial products to customers who sometimes did not understand what they were getting into.

No one believes that derivatives actually caused the crisis. But although the point is bitterly contested by some investment bankers, a number of economists believe that once the crisis started, derivatives helped deepen it and infect other countries. They cite several mechanisms.

Rushing to the Exits

First, derivatives made it easier to make high-risk bets on Asia, but these were not publicly reported. As a result, no one had any idea how much betting was going on.

"Derivatives enabled a lot of hot money to flow into Asia below the radar," said Frank Partnoy, a former derivatives salesman and now an assistant professor of law and finance at the University of San Diego.

Second, the riskiness creates a rush to cover bets when the market goes the wrong way, and this scramble sometimes causes wild market swings.

As Partnoy explained the scramble: "It's as if you're in a theater, and say there are 100 people and you have the rush-to-the-exit problem. With derivatives, it's as if without your knowing it, there are another 500 people in the theater, and you can't see them at first. But then when the rush to the exit starts, suddenly they drop from the ceiling. This makes the panic greater."

Third, derivatives increased the linkages from one country to the next. South Korea, in particular, invested in derivatives and other high-risk securities that were tied to Thailand, Russia, Indonesia and Latin America. South Koreans bought 40 percent of one Russian bond issue and almost all of a Colombian bond issue.

So when those countries soured, South Korean financial institutions were badly hit as well. Derivatives had allowed them high yields but also meant that they stood to lose far more than their principal.

"I think it is quite clear that derivatives are vectors of contagion," said Martin Mayer, a senior fellow at the Brookings Institution in Washington.

Why did derivatives flourish in Asia? One reason was that until the crisis, they were enormously profitable for everyone. Some Asian financial institutions now grumble about them, but until a couple of years ago Korean mutual funds managed to earn exceptionally high returns in part because of their derivative investments.

Moreover, American banks often made huge sums selling these products in Asia. Jan Kregel, who has researched the issue as a senior fellow at the Jerome Levy Economics Institute in Annandale-on-Hudson, N.Y., concludes that in the boom years of both Thailand and Indonesia, Western banks made incomparably more money selling derivatives than making loans, and that in any case much of the lending was linked to derivatives as well. Most of the major American banks -- Bankers Trust and Chase and J.P. Morgan and others -- were actively selling derivatives in Asia.

The problem was not that Westerners were fleecing Asians, for in Asia one of the biggest derivatives players was a Hong Kong investment bank, Peregrine Investments, run by a British former race-car driver named Philip Tose. Founded only in 1988, Peregrine came from nowhere to register an astonishing $25 billion in revenues in 1996.

Then, early last year, Peregrine returned to nowhere. It collapsed in a sea of debts in Indonesia and elsewhere, and the shock then rippled through Asia and around the world.

"It was a major local player," said Christopher Barlow, a finance expert at PricewaterhouseCoopers who is presiding over the liquidation of Peregrine. "A collapse like this causes shock waves in the system and damages confidence." Barlow said Peregrine had more than 2,000 creditors, with claims of more than $4 billion.

One of the losers was the Illinois state pension fund, which manages Mrs. Paoni's retirement money. The fund had bought $358,000 of Peregrine stock, all of it now worthless, although this had only an infinitesimal effect on Mrs. Paoni's holdings.

"Derivatives are like power tools," said Brian Lippey, managing director of Tokai Asia Ltd., an investment company in Hong Kong. "If you know how to use them, they're great. But if you don't know how to use them, you'll drill a hole in your head."

No Fares, No Food

In the Indonesian town of Mojokerto, high finance began to close in on Salamet, a rickshaw driver.

Salamet (who like many Indonesians uses only one name) cannot read, so he had not learned from the newspaper that the Thai baht had plummeted and the Hong Kong market had plunged. But he was shocked when Agus Santoso came home.

Santoso, a slight 40-year-old neighbor, too frail a man to make a decent ditch-digger, had been the talk of the town. He had managed to learn how to drive a car and had got a job driving new cars to dealerships all over Indonesia.

The job paid $400 a month, a colossal sum that had tongues wagging all over the neighborhood. Salamet had dreamed that he, too, might learn to drive a car and follow in Santoso's lead.

But cars and car parts are imported, so they began to soar in price as the Indonesian rupiah lost value. Indonesians stopped buying new cars, and Santoso was dismissed and moved back home.

Meat and rice soared in price, and people in Mojokerto began to cut back to two meals a day. The poor began to walk instead of taking rickshaw rides, and Salamet's earnings fell by half, to less than $1 a day.

It is still unclear how severe the impact has been across the region, and the last few months have seen a statistical battle, as international organizations and aid agencies have issued a flood of reports offering widely divergent portraits of Asia in crisis. Invariably, the bleakest assessments have tended to get the most attention.

In Indonesia, for example, estimates by the government and some aid agencies have suggested that the proportion of people living in poverty has risen to 40 percent or even 50 percent. But three carefully prepared World Bank reports released in January suggest that the increase has been much more modest, to 13.8 percent in 1998 from 11 percent in 1997.

As the World Bank sees it, "Rather than the universal devastation in poverty, employment, education and health so widely predicted and repeated in the media," the reality is increased poverty and a rising number of school dropouts, but not on the scale that aid agencies had suggested.

Still, although the scale is uncertain, everyone agrees that the crisis has left millions of people in great distress. And in Salamet's extended family, there is no doubt that life has taken a turn for the worse, even if it is difficult to measure.

Salamet took his wife, Yuti, and their baby daughter to visit his in-laws in a village near Mojokerto, and there they sat down beside a hut to chat. No food was served, for there was none.

The matriarch, Sambirah, who does not know her age but appears to be in her 80s, cradled her great-granddaughter in gnarled arms so frail that they seemed to rattle in the breeze, and for a moment her rheumy eyes glowed with pride. Mrs. Sambirah's pale mouth turned up at the corners, revealing two yellowed teeth, tusks emerging from an expanse of gum.

Then the tusks disappeared, and Mrs. Sambirah's eyes clouded. She sighed and described how she now pawns her sarongs so that the children do not starve.

"I can put up with it if I don't eat," she said. "But the children aren't used to it. They cry and cry."

Pulp Facts, Pulp Fiction

Across the globe, on the 22nd story of a skyscraper in Rio de Janeiro, Carlos Aguiar began to feel Indonesia's pain.

Aguiar, 53, president and chief executive of a pulp and paper company called Aracruz Cellulose SA, is solid and plain-speaking. His hair is neatly parted on the side; his manner suggests a waltz rather than a samba. He worked his way up through the business, and his heart is not in Rio but 375 miles north in the company town of Aracruz, where most company timber plantations and pulp mills are.

Mrs. Paoni is among those with a stake in Aracruz. Her state pension fund bought into the Brinson Emerging Markets Fund, which in turn owned 102,000 shares of Aracruz preferred stock.

Many investors picked up Aracruz, for the paper industry was doing well in the mid-1990s and investment analysts were recommending the stock. But a problem was developing behind the scenes: Asian companies were building a quantity of enormous paper mills in Indonesia and other countries, dramatically increasing worldwide output. Global pulp capacity has soared to 35 million tons, from 25 million tons in 1990.

"Everybody saw Asia as being this great market," Aguiar said morosely. "China, India, they have enormous populations, and everybody was betting on them. That was why the Indonesians built these giant factories, because they were expecting that paper use in China would go from 17 kilos a person now, to 30, then to 100. It didn't happen."

On top of the glut, the devaluations in Asia meant that Indonesian companies lowered their prices. So the price of Aracruz pulp dropped to $420 a ton recently from $850 a ton at its peak in 1995.

Pulp offered simply one example of a global slump in commodity prices. The world abruptly found itself bedeviled by excess capacity just as demand slumped, and so markets were awash with Russian steel, Chilean copper, American grain, Colombian coffee and Saudi oil.

Astonishingly, after one of the great booms in economic history, commodity prices on average are still 12 percent lower than the average in 1990. Metals on average now cost just two-thirds as much as eight years ago. After adjusting for inflation, oil costs less than it has for 25 years, since before the 1973 oil shock.

Debt Addict Seeks Rx

Falling commodity prices were making ripples around the world. They were especially brutal to Russia, whose main export is oil and gas, with the upshot that Russia's economy was falling apart.

Nobody much noticed at first. As with Asia a year earlier, it was too easy to be dazzled by the black Mercedes-Benzes, the diamond rings and the crowded discos. In 1997, Russia's stock market performed the best in the world, rising 149 percent in dollar terms, according to the calculations of the International Finance Corp.

At GUM department store, Solomatin, the chairman, had been equally optimistic. He had sunk GUM's entire nest egg of liquid assets -- then worth $33 million -- into the stock and bond markets. It had seemed a good deal, for the bonds were paying interest rates of 100 percent or more.

But behind the scenes Russia's economy was showing severe strains, and many of them were unrelated to the Asian crisis. Tax collection was abysmal, government budget deficits were growing, short-term debt was rising and President Boris Yeltsin's health seemed to be fading.

Asian countries had had problems with private debts, but Russia's problems were a bit different: the government itself was addicted to debt. And with one-third of government revenues coming from taxes on oil and gas that were steadily falling in price, it was difficult to foresee an improvement.

"I think the main reason for our crisis was not the Asian crisis," said Sergei Kiriyenko, who at 37 became Russian prime minister last spring. "It was that for years we had expenses higher than revenues."

More broadly, in contrast with Asia and Latin America, where markets were deeply rooted, Russia had only the flimsiest attachment to market principles and was being savaged by corruption and organized crime. Russia's top prosecutor, Yuri Skuratov, estimates that half of all Russia's commercial banks are mob-controlled and that criminals control about half of the gross national product.

Even as Russia's economy was quietly disintegrating, public support from the United States, Germany and other countries bolstered the impression that, as one economist put it, Russia was "too nuclear to go bust."

In July 1998, the Clinton administration pushed the monetary fund for a major bailout, even though officials worried privately about whether it would work. In the end the fund worked out a $17.1-billion deal.

Perhaps Americans did not fully notice the crisis developing, but Russians did -- and their behavior undermines the notion that around the world it was only Western investment bankers who took poor locals to the cleaners. In Russia it was more the other way around. Russian capital flight steadily averaged $1 billion per month for the last three years, moving to places like Britain and Switzerland, which Russians felt they could trust. The first $4.8 billion installment of the fund bailout quickly disappeared as Russian oligarchs cashed out their rubles and took their money out of Russia.

As Charles Dallara of the Institute of International Finance in Washington described it, "So in a broad sense, you had the West, the IMF, Western banks and Western governments pouring money in the front door, and a select group of Russian citizens taking it out the back door."

Meanwhile, the Russian legislature balked at many of the required reforms. Investors panicked, and on Aug. 17, computer screens flashed the bad news: the bailout had collapsed, and Russia stopped propping up the ruble and defaulted on domestic bonds. Overnight, the bonds were virtually worthless, and stocks fell from dollars to pennies.

Still, Rubin says he has no regrets about the July bailout. "I'd do the same thing again," he said. "Given the stake we had in an economically viable Russia, it was a risk worth taking. It had a realistic chance."

GUM, which had been seeking listings on overseas stock exchanges, sent despondent faxes that day to its investment banker friends, postponing those plans indefinitely. The crisis sent the ruble tumbling to more than 18 to the dollar from 6, and so in effect all the imports in GUM (and most of the inventory is imported) tripled in price just as Russian consumers were losing their jobs.

The shock waves from the Russian default were felt around the world, partly because they shattered the assumption of an international safety net. The United States and the monetary fund had wanted to save Russia, and their failure sobered investors, sending them scurrying once more away from risk.

After the Russian crisis, the upheavals in international markets nearly destroyed Long-Term Capital Management, the most glamorous of America's hedge funds. More than a year earlier, the hedge funds had helped to trigger the financial crisis in Thailand, setting in motion a chain reaction that ultimately came back to take Long-Term Capital to the brink of collapse.

Long-Term Capital tumbled for the same reasons that Thailand did. American financiers may like to think of themselves as a world apart from Thai bankers, but there was a certain symmetry in what went wrong.

Thailand and Long-Term Capital were both victims of their own successes, which bred hubris and carelessness toward risks. They also both borrowed more money than they should have, and got into trouble when their bets went wrong. And, to be fair, both had a certain amount of bad luck.

On When to Bail Out

The Russian default sideswiped Brazil, which for a time lost money from foreign reserves at the rate of $1 billion a day. So when Brazil wobbled, the United States braced itself. In November 1998, the Brazilian government agreed to a $41.3-billion bailout package from the fund, which Clinton arranged early, while Brazil was still solvent.

For the United States it was a remarkable turnaround. A bit more than a year earlier, the Clinton administration had refused to contribute money to the Thai bailout and had prevented Japan from distributing aid. This time, Clinton himself led the intervention and the United States came up with $5 billion of the package.

Yet it was a bad bet. Despite widespread recognition that the Brazilian currency, the real, was overvalued, Washington made essentially the same mistake as it had in Russia: it trusted the legislators to quickly pass reforms that would reassure investors. Again the markets won, and in January Brazil was forced to float the real.

The collapse of the currency in turn forced Brazil to raise interest rates to try to attract foreign money -- the pattern that had occurred a year earlier in Indonesia or South Korea. And the high interest rates, in turn, are depressing Brazil's economy and casting a shadow over Argentina, Mexico and all of Latin America.

At Aracruz, Aguiar has solemnly watched the stock price fall, from $22 a share in the summer of 1997 to $11.81 on Tuesday. Over the years, he has taken desperate measures to compete globally, trimming Aracruz's work force by nearly two-thirds, cutting back on health and dental benefits, and turning to a cheaper contractor to run the company cafeteria. Just since the crisis hit in the fall, he has pared staffing another 10 percent, and he prays it will be enough.

On the other end of the globe, in the third floor boardroom of GUM, Solomatin has a grand view of Red Square -- and a terrible view of his company's future.

All the company's plans are on hold; the money in defaulted bonds is locked up; all the stock is now worth only $36 million, about the cost of the inventory.

That makes GUM a candidate for a takeover by a foreign company, and two European companies are said to have been eyeing it. But Solomatin sounds skeptical.

"Who would take us over?" he asked. "Investor fear of Russia is so great that nobody would consider buying us."

Reformatted for mugajava website.
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