The New Republic October 5, 1998

The Confidence Game

By Paul Krugman

How Washington worsened Asia's crash.

Even in private, officials at the International Monetary Fund and the U.S. Treasury Department still think that they did the right thing on Asia and that their medicine will eventually work. And they do have some favorable numbers to cling to: interest rates in South Korea and Thailand have been dropping, and, with the exception of Indonesia, the collapse in output--devastating as it has been--is no worse than that of Mexico in 1995. But most people outside Washington's corridors of power are far less sanguine: they are all too aware that, at every point in this crisis, the real consequences of financial turmoil have been worse than anyone anticipated and that, in recent weeks, the crisis, far from being contained, has appeared to be spreading, especially to the hitherto largely immune economies of Latin America.

The human and economic costs of the slump are self-evident, as is the damage to Western influence. Less attention, however, has been paid to the effects of this crisis on the credibility of America's economic policy-making establishment. So it is not too soon to make sure that the story of what went wrong is told the right way.

Here is how I fear the story will get told: The best and the brightest--the smartest economists in America--went to Washington; they applied orthodox economic analysis to Asia; and the result was disaster. So, from now on, let's ignore the advice of economists and rely on businessmen, or journalists, or, at least, somebody without intellectual pretensions to make economic policy.

This story is half-right. The best and the brightest did indeed go to Washington. Never before in history, as far as I can tell, have so many first-rate academic economists held so many high policy positions. (Deputy Treasury Secretary Lawrence Summers and his team, in particular, are an unprecedented group of all-stars.) But they did not apply orthodox economic analysis. On the contrary, from the very beginning of the crisis, the response from Washington has been to throw away the textbooks. If orthodoxy has been applied, it has been that of bankers, not economists.

Why? Because, from the beginning, Washington's preoccupation has been not economic fundamentals but market confidence. And what does it take to restore confidence? Policies that may not make sense in and of themselves but that policymakers believe will appeal to the prejudices of investors--or, in some cases, that they believe will appeal to what investors believe are the prejudices of their colleagues.

Whatever one's views about the ultimate causes of the Asian crisis, the proximate cause--the shock that turned miracle into debacle--is not in dispute: the global capital market did it. Right up to the eve of the crisis, Asian economies could, in the eyes of people with money to invest, do no wrong. In 1996 alone, foreign banks lent the countries now in crisis more than $100 billion, and nonbank investors poured in tens of billions more. These enormous inflows of capital allowed Asian countries to spend far more than their incomes. In the second half of 1997, however, those same banks called in more than $50 billion worth of loans.

Now suppose that you were to buy a copy of the best-selling 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 coauthor of that textbook.) But, to the extent that it does offer an answer, it suggests that the affected country should try to roll with the punch: let its currency decline, maybe even cut interest rates to keep the economy from slumping. That, after all, is what the United States did in 1985, when markets finally began to wonder whether the mounting trade deficits of the early Reagan years could be sustained forever. We cheerfully let the dollar slide from 240 yen to 140, from three Deutsche marks to 1.8; the Fed even helped the process along by cutting interest rates; and the U.S. economy continued to expand.

When the Asian crisis struck, however, the response that Washington urged on the afflicted nations--and demanded as a condition for emergency IMF loans--was very different. True, countries were not told to defend their exchange rates at all costs: the baht, the won, and the rupiah were allowed to slide against the dollar. But countries were told to raise interest rates, not cut them, in order to persuade some foreign investors to keep their money in place and thereby limit the exchange-rate plunge. And they were implicitly told to accept the resulting recessions--recessions that have, admittedly to everyone's surprise, turned out to be the world's worst since the 1930s. In effect, countries were told to forget about macroeconomic policy; instead of trying to prevent or even alleviate the looming slumps in their economies, they were told to follow policies that would actually deepen those slumps.

So where was recovery supposed to come from? Well, reform--closing the bad banks, getting rid of the cronies--was supposed to bring about a restoration of confidence. Do the right thing, countries were told, and international capital will eventually come flooding back.

It is still possible that this was the right policy--that the alternatives would have been even worse. But, right or wrong, Washington's response to the Asian crisis represented a break with, even a betrayal of, a sort of deal that capitalism and its economists made with the public two generations ago.

Call this deal the "Keynesian compact." Its origins lie in the 1930s, when it was natural for even moderate observers to conclude that free markets had failed and that only a highly regulated economy, perhaps even a centrally planned system, could avoid devastating economic slumps. What restored faith in free markets was not just the recovery from the Depression but the assurance that macroeconomic intervention--cutting interest rates or increasing budget deficits to fight recessions--could keep a free-market economy more or less stable at more or less full employment. And, in the United States, that compact has been honored. Oh, there are recessions now and then. However, when they occur, everyone expects the Fed to do what it did in 1975, 1982, and 1991: cut interest rates to perk up the economy.

But, when it comes to "emerging market" economies, suddenly the deal is off. Look at what is happening right now in Brazil--a country which has carried out substantial economic reforms, moving toward much freer markets, but whose unemployment rate has been steadily rising for the past few years. Inflation in Brazil is low; by rights, one might expect the country to be able to cut interest rates and get some job creation under way. Instead, Brazil is being urged to avoid a devaluation of its currency, the real, at all costs. And to keep the real stable, it is told, it must raise interest rates to punitive levels and slash the budget deficit. In other words, far from fighting the slowdown in its economy, Brazil--like Thailand and South Korea--is being instructed to take steps that will clearly ensure a nasty, perhaps disastrous, recession.

Again, maybe this is the right advice. But why did the high-powered economists near the top of the IMF and the Treasury, as soon as they encountered a crisis, throw away the textbooks--indeed, do almost the opposite of what the textbooks would have suggested?

Of course, Thailand is not the United States. Imports are a much larger share of consumption, so that too large a currency depreciation could produce a surge in inflation--perhaps even a runaway wage-price spiral. Also, many corporations and banks in Asia have large dollar debts; a sharp drop in their currencies, which would make those debts suddenly far larger in baht or won or rupiah, might push those borrowers into insolvency. So even economists who strongly believe in benign neglect when it comes to the dollar become more cautious when it comes to the currencies of small developing countries.

But there is a deeper reason why the policies Washington urges on developing countries are so different from those it follows at home: fear of speculators.

Imagine an economy that isn't perfect. (What economy is?) Maybe the government is running a budget deficit that, while not really threatening its solvency, is coming down more slowly than it should, or maybe banks with political connections have made too many loans to questionable borrowers. But, as far as anyone can tell by going over the numbers, there are no problems that cannot be dealt with given goodwill and a few years of stability.

Then, for some reason--perhaps an economic crisis on the other side of the world--investors become jittery and start pulling their money out en masse. Suddenly the country is in trouble, its stock market plunging, its interest rates soaring. You might think that savvy investors would see this as an opportunity to buy. After all, if the fundamentals haven't changed, doesn't this mean that assets are now undervalued? Not necessarily. The crash in asset values may cause previously sound banks to collapse; an economic slump plus high interest rates may cause sound companies to go bankrupt; and, at worst, economic distress may cause political instability. Maybe buying when everyone else is rushing for the exits isn't such a good idea after all; maybe it's better to run for the exit yourself.

Thus it is possible in principle that a loss of confidence in a country can produce an economic crisis that justifies that loss of confidence--that countries may be vulnerable to what economists call "self-fulfilling speculative attacks." And, while many economists, myself included, used to be skeptical about the importance of such self-fulfilling crises, the experience of the '90s in Latin America and Asia has settled those doubts, at least as a practical matter.

True, many of the investments made in Asia in recent years now look extremely foolish, and it seems only natural to conclude that they were the product of a deeply corrupt "crony" system--and that the massive loss of investor confidence in Asia was therefore wholly justified on that basis. But how sound would our own financial institutions look if we experienced a comparable loss of investor confidence? Scaling up Thailand's experience to the size of the U.S. economy, it would be as if the roughly $200-billion-per-year net inflow of foreign investment that currently helps stabilize our financial markets were next year to become an outflow, not of $200 billion, but of a trillion dollars. How many loans that looked reasonable at the time would suddenly become "nonperforming"? How many seemingly sound banks would be defunct? In short, whatever the sins of the Asian economies, it's important to understand that most of what is now wrong with them is the consequence, not the cause, of their crisis.

Big, rich countries like the United States are generally invulnerable to such a self-ratifying loss of market confidence and can still operate on the assumption that the financial markets will more or less appropriately reward good policies. But smaller countries, with a shorter record of economic success, are always at risk--and avoiding such collapses of confidence becomes a central concern of economic policy.

The peculiar thing is that, because speculative attacks can be self-justifying, following an economic policy that makes sense in terms of the fundamentals is not enough to assure market confidence. In fact, the need to win that confidence can actually prevent a country from following otherwise sensible policies and force it to follow policies that would normally seem perverse.

Consider again the plight of Brazil. Many economists believe Brazil's currency is overvalued--that is, if one could ignore the question of market confidence, the country would benefit from a devaluation that would make its exports more competitive on world markets. Examples of successful devaluation abound: the drop in the value of Britain's pound in 1992, while a humiliation for the government, led to a rapid economic recovery that was the envy of continental Europe. But Brazil's leaders (and Washington officials) fear, with good reason, that investors hold developing countries to a different standard: that any comparable move in Brazil would be the signal for a massive run on the currency and would be an economic catastrophe. It's not that devaluation is a terrible thing per se, but investors believe that it would be, and, in a world of self-fulfilling crises, believing makes it so.

The same logic applies to Brazil's interest rate and budget policy. Raising interest rates to defend the currency may be a destructive policy from a strict economic viewpoint; so is reducing spending and raising taxes in the face of a recession. But investors believe that, if Brazil does not do these things, there will be a terrible crisis, and they are surely right, because they themselves will generate that crisis.

Now consider the situation from the point of view of those smart economists who are making policy in Washington. They find themselves dealing with economies whose hold on investor confidence is fragile; almost by definition a country that has come to the United States and/or the IMF for help is one that has already experienced a devastating run on its currency and is at risk of another. The overriding objective of policy must therefore be to mollify market sentiment. But, because crises can be self-fulfilling, sound economic policy is not sufficient to gain market confidence; one must cater to the perceptions, the prejudices, and the whims of the market. Or, rather, one must cater to what one hopes will be the perceptions of the market.

In short, international economic policy ends up having very little to do with economics. It becomes an exercise in amateur psychology, in which the IMF--whose top economist, Stanley Fischer, boasts credentials just as impressive as those of Summers and his crew--and the Treasury Department try to convince countries to do things they hope will be perceived by the market as favorable. No wonder the economics textbooks went right out the window as soon as the crisis hit.

Unfortunately, the textbook issues do not go away. Suppose that Washington is right, that a country threatened with an investor panic must raise interest rates, cut spending, and defend its currency to avoid devastating crisis. It still remains true that tight monetary and fiscal policies, together with an overvalued currency, produce recessions. What remedy does Washington offer? None. The perceived need to play the confidence game supersedes the normal concerns of economic policy. It sounds pretty crazy, and it is.

During the past four years, seven countries-- Mexico, Argentina, Thailand, South Korea, Indonesia, Malaysia, and Hong Kong--have experienced severe economic recessions, worse than anything the United States has seen since the '30s, essentially because playing the confidence game forced them into macroeconomic policies that exacerbated slumps instead of relieving them. It now looks extremely likely that Brazil will be forced down the same route and that much of the rest of Latin America will follow. This is a truly dismal, even tragic, record. Isn't there a better way?

Well, as long as countries are wide open to massive movements of hot money--to huge inflows when the markets like them, then to equally large outflows when confidence is shaken for some reason--the answer is no. As long as capital flows freely, nations will be vulnerable to self-fulfilling speculative attacks, and policymakers will be forced to play the confidence game. And so we come to the question of whether capital should really be allowed to flow so freely.

Of course, it is not easy to limit the international movement of capital--at least not without threatening to strangle international trade as well. Discuss the issue with the experts in Washington, and they will raise many pointed technical objections. They will also remind you that, in 1995, the IMF and the Treasury Department played the confidence game on behalf of Mexico and Argentina and won it.

But they do not seem to be winning this time. And even if, miraculously, Asia recovers and Latin America avoids disaster, and even if another crisis does not materialize a couple of years later, the Keynesian compact will still remain broken: developing countries will consistently find that, when a recession strikes, financial markets force them to act in a way that makes that recession even worse.

Maybe such a system can survive, but I doubt it. If allowing free capital movement means that economic policy must play by the rules of the confidence game, sooner or later the world is going to decide that it is a game not worth playing.

Paul Krugman is professor of economics at MIT.

(Copyright 1998, The New Republic)