When wild dogs barked at Wall St

The Chastening
May 23, 2003

At the end of the 1990s, there was a great deal of economic and financial turbulence in the previously extremely dynamic economies of East Asia. An associated flurry of activity occurred within domestic and international financial institutions. Senior personnel of these institutions, and especially the International Monetary Fund, rushed around the world like firefighters trying to cope with the developing "crises".

Trouble struck first in Thailand in the late summer of 1997, but before long South Korea, which had been an astonishingly good performer, was also in difficulties. Indonesia followed, with problems greater than the other two. Stock prices collapsed and exchange rates plummeted. Brazil and Russia also had serious problems. Many others, such as Hong Kong, experienced substantial volatility in their financial markets. And a major hedge fund was in the process of collapsing.

This was all evidence to some, and grist to the mill of many, that there was something badly wrong with the world. To them it was clear the problem was globalisation and the work of sinister multinationals - the inevitable consequences of unrestrained and rampant capitalism. Protest demonstrations appeared on the streets of cities wherever IMF or similar-type meetings were taking place.

Not only was there a lot of activity in the world's central banks and international financial institutions, and even more on the streets, but there was also a great outpouring of views from the academic world, financial and economic journalists, and even from some leading practitioners such as George Soros.

Much of this was critical of the structure of the existing "international financial architecture", as the various elements in the international financial system came to be called. At the centre of such criticism, was the role that the IMF played.

This particular account of the events is by a financial journalist who took time out from his Washington Post job to try to make sense of the events, and offer another prescription for future avoidance. It is a good story well told. Paul Blustein's account of the unfolding of events and description of the dramatis personae is detailed and full of interest, with stories of, for example, how the IMF's managing director was easily brought in to South Korea without attracting unwanted media attention because as Kim Ki Hwan, the ambassador for economic affairs, said: "Most Koreans cannot tell one western face from another." It is peppered throughout with little snippets, such as the story of the distinguished Cambridge economist, Joan Robinson, in the 1960s hailing the industrial development of North Korea as a miracle and predicting that it would economically overwhelm the "degenerating" South. Blustein also explains all the technical terms and jargon as he goes along so that the uninformed reader can follow more easily terms such as "risk arbitrage" and the like.

The story does not differ greatly from many of the others around. It is a tale of ignorance and incompetence at the top coupled with the herd instinct at work among investors. It is dramatised with language closer to a thriller than conventional economic commentary. So it is the global economy's "high command" together with the "electronic herd" who wrought the havoc, and there are references to the "slaughter" that was under way.

The very title of the book is suggestive of the film to follow. The desire to dramatise leads the author to overstate his case when for instance he says: "Most chilling of all was how perilously close the US economy came to joining the global meltdown inI 1998I (when) the convulsions on Wall Street might well have engendered a worldwide slump." That is surely going too far.

The core of the story is that the East Asia crisis was one of confidence rather than fundamentals. As such it did not need the fiscal and monetary austerity measures imposed by the IMF. He notes along the way that the banking systems of the countries involved were not all that they might have been, but that is not significant for his explanation.

Blustein undoubtedly hits a lot of good targets as he goes along. The Japanese model is one. The IMF has come in for all kind of criticisms and he joins in with gusto. On Korea: "Clueless as it was, the IMF report...."; and in the closing months of 1997 "Indonesian financial markets were registering the full force of the compounding blunders that had been committed by the IMF and the Suharto regime". On Thailand the IMF "miscalculated badly". Perhaps so, but the central issue in the events needs to be addressed head on.

At the centre of his account lies the old bogey of contagion: "Is the world truly prepared to stand by while the dogs of financial contagion run wild?"

Contagion is a word that has been bandied about in many discussions of the problems. It is seldom clear what it means. Too often it is simply post hoc ergo propter hoc , which runs the danger of simply asserting that when one crisis follows closely on the heels of another, one causes the other. But the fact that several countries had problems in close succession does not mean that they were causally related.

A better explanation is that these countries had weak financial systems, defective exchange-rate regimes or central banks that did not appropriately perform their key function of lender of last resort. These are fundamentals, not issues of confidence. Investors did not trouble themselves about such weaknesses since the likelihood was that default would not be allowed either by domestic governments or by international assistance - the moral hazard created by previous rescue operations. Then, when investors began to doubt the intentions or the capability of the rescuers, they took away their capital.

The prescriptions that follow from Blustein's story are inevitably faulty.

While alluding to many of the problems from which these several countries suffered, his prescriptions come down to just two, and they derive from his identifying capital flows as dangerous and needing to be curtailed. First, he suggests a cull of investors who take short-term decisions (called "shorthorns") - by cutting back on capital flows, the intensity of crises would be reduced. The best way to do this is the old prescription of taxing capital flows. Second, he argues that bail-in schemes (somehow tying investors in to projects) should be devised to stop panicky withdrawals.

All of this largely glosses over the fact that there were economies in the region that did not suffer the wild oscillations in prices or pressure on their exchanges that the others did. This was because they had generally behaved properly and had relatively prudent and appropriately structured banking systems, in conjunction with sensible monetary and fiscal policies.

These provided financial stability, which underpinned stability in the economy as a whole.

Nevertheless, this book is a gripping account by someone who knew or interviewed many of the participants and knows a great deal about the institutions and their operations. For that alone it is worth having.

Forrest Capie is professor of economic history, Cass Business School, City University, London.

The Chastening: Inside the Crisis that Rocked the Global Financial System and Humbled the IMF

Author - Paul Blustein
ISBN - 1 903985 25 0
Publisher - Public Affairs Ltd.
Price - £19.99
Pages - 432

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