The Washington Post, Wednesday, October 14, 1998

Change Nobody Understands

By Robert J. Samuelson

Donald Tsang, a dapper man who favors bow ties, is no bomb thrower. He routinely extols the virtues of free markets and, as the chief economic official of Hong Kong, has guarded its capitalist reputation since its return to China in 1997 under the doctrine "one country, two systems" (meaning Hong Kong could run its economy and legal system, while China controlled its security). Yet in August, Tsang discarded his free-market instincts and stomped into the local stock market to buy shares. Put simply, he tried to manipulate the market.

It was a shock -- and an apt symbol of the turmoil engulfing the world economy. The tumult stems from an onslaught of shocks, and if Hong Kong's stock-market gambit doesn't seem sufficiently sensational, you can select from other candidates. In August, Russia defaulted on government debt. After that Malaysia imposed currency controls that barred investors from withdrawing their funds. Later the Long-Term Capital Management hedge fund escaped bankruptcy only through a rescue inspired by the Federal Reserve.

It is hard to bring coherence to these events, because there is no coherence. The story -- the real "news" -- is disorder. Last week thousands of the world's top economic officials (including Tsang) and private bankers assembled in Washington for the annual meetings of the International Monetary Fund and World Bank. These huge gatherings are usually ceremonial affairs, but this year's unstated agenda was to restore confidence: to create a feeling that major governments had a command of the situation.

This didn't happen. Even Michel Camdessus, the IMF's ever-optimistic head, noted "a common sense of disquiet." One economist who attended private meetings among government officials and bankers reported the "gloom was almost palpable." Meanwhile, stock, bond and foreign-exchange markets fluctuated wildly. Bad news means more instability. One indicator: Since 1945 the U.S. stock market (measured by the Dow) has about six days a year when it moves up or down at least 2 percent, reports Birinyi Associates; since July 17 there have been 13 such days (through Oct. 12).

If disarray is the story, it has at least three causes. The first is a continuing collision between governments and footloose global capital. Consider Hong Kong. Tsang believes that if he did not intervene, "Hong Kong just collapses the same way as Korea or Thailand." Hong Kong is already in recession. Unemployment is the highest in 15 years. Output may drop 5 percent in 1998. Stock prices have declined roughly 50 percent from their peaks. But speculative assaults, Tsang says, could worsen everything.

As he relates it, global investors -- probably hedge funds and investment houses -- attacked on two fronts. First, they sold Hong Kong dollars for U.S. dollars. Second, they sold short on the Hong Kong stock market; this meant they would profit if the market dropped. Here's what speculators intended to happen. Because Hong Kong operates a currency board that backs all Hong Kong currency with U.S. dollars -- at a fixed exchange rate -- selling Hong Kong dollars withdrew them from circulation. By itself this would raise interest rates, depress stock prices and generate profits for short sellers.

"It was a contrived game," Tsang says, "[to] make the local population panic." Interest rates could have gone to 50 percent, he says. "No government, even with the freest markets, could stand idly by and let that happen." So Tsang disrupted the game. He abruptly bought stocks, boosted their prices and inflicted losses on short sellers. (If stock prices rise, short sales become unprofitable.)

Tsang's counterattack was understandable and defensible. But there are ripple effects. The same impulse -- the desire to shield nations against global money shifts -- prompted more dubious reactions (Russia's default and Malaysia's currency controls). The ripple effects are simple. No one knows what the rules are. Uncertainty and fear mount; so do financial losses. Investors withdraw funds from countries that otherwise might have been safe. Losses from one market spill over into others.

What compounds the disorder is its second basic cause: an intellectual vacuum. Governments and the IMF rely heavily on economists for advice, but they only vaguely understand how these vast money flows affect the world economy. Here is a stunning confession from economist Paul Krugman of the Massachusetts Institute of Technology in the New Republic magazine: "Now suppose that you were to buy a copy of the bestselling textbook on international economics. What would it tell you about how to cope with such a sudden loss of confidence by international investors? Well, not much. (Trust me -- I'm the co-author of that textbook.)"

Gulp. As a result, the process of managing this crisis has been a giant and, so far, largely tragic learning experience. Economists generally haven't integrated finance -- money, banking, stock and bond markets -- into their models of how the global economy operates. Indeed, their ignorance encouraged an excessively rapid dismantling of barriers to global capital flows.

The final element fostering disorder is weak political leadership. Let's see. President Clinton faces an impeachment inquiry and, for more than a year, has argued with Congress about approving the full $18 billion U.S. contribution to the IMF. Japan has been debating various measures to rescue its banking system and revive its economy -- well, forever. In Europe, Britain, France and Germany all have new and inexperienced governments.

What remains is an interplay of rising nationalism and retreating global finance that isn't well understood and, even if it were, might not be controllable by today's political leaders. These forces may or may not ultimately upset America's and Europe's prosperity. But they have damaged the confidence of both investors and consumers. In Washington last week, Tsang had one refrain: "We are all in the same boat." This is true. The trouble is that no one is steering, and the passengers and crew are growing confused and demoralized.