Panel 3: |
Not For Quotation Without Permission Are We in a Global Economic Crisis? Edwin M. Truman Remarks at April 17, 1999 Following the Russian devaluation and default on August 17, 1998, and the associated near meltdown in international financial markets, President Clinton stated on September 14, “This is the biggest financial challenge facing the world in a half century.” Two weeks later (on October 1), Secretary Rubin reported on the cooperative effort to deal with that challenge, “In the short-term, the international financial community has worked aggressively to face the immediate tasks of limiting the damage from what is generally viewed as one of the most serious financial challenges of the last fifty years and helping the affected emerging markets return to stability and growth.” Allowing for a bit of Washington hyperbole, it is fair to say that the international financial system has faced a series of difficult challenges over the past two years, challenges that culminated last summer and fall with the Russian and Brazilian crises and at least risked a collapse in the global financial system and, more important, the global economy. It is also fair to say that viewed from the perspective of April 1999, the crisis passed, at least for the moment. However, we have an uneasy sense that the international financial system is more crisis-prone today. One is tempted to speculate about the reasons. Is it because the world economy is more global and more integrated? Are the shocks different? Are markets behaving differently because of the influence of technology? Is the incidence of crises no different, but do market participant have shorter memories, not having benefitted from a solid grounding in economic history at Yale University? I do not know the answers to these questions, and I do not have the time or short-run mental capacity to suggest definitive conclusions, though I suspect that a reasonable answer is all of the above and probably more. I do know that we have not been in a continuous crisis since the floating of the Thai baht on July 2, 1997; we have had a series of crises that have been more or less linked together -- a point to which I will return in a moment. Crises by definition have short time dimensions; we economists have borrowed the term from our medical colleagues and have tended to stretch it. The dictionary I consulted [The American Heritage Dictionary of the English Language, 1969] provides a reasonable definition, “an unstable condition in political, international, or economic affairs in which an abrupt or decisive change is impending.” Kindleberger responded to criticism of the first edition of his Manias, Panics, and Crashes: A History of Financial Crises that his book lacked a definition of crisis by adopting the definition of one of his critics, Yale’s own Raymond Goldsmith, “ a sharp, brief, ultracylical deterioration of all or most of a group of financial indicators -- short-term interest rates, asset (stock, real estate, land) prices, commercial insolvencies and failures of financial institutions.” Kindleberger also noted that the Goldsmith definition “excludes foreign exchange difficulties as a necessary feature.” [page 3] Nevertheless, unexpected changes in exchange rates are often considered to be an ingredient of financial crises, at least international financial crises, and arguably many, but not all, domestic financial crises today become international financial crises. My former colleague and fellow Yale PhD, Lewis Alexander, and his Federal Reserve associates have examined the question of the increased incidence of currency crises, defined as unexpected changes in monthly real exchange rates for 15 emerging market economies in Latin America and Asia in the 1980s and 1990s. They found no obvious upward trend in crises over the entire period. However, the period 1991 to 1996 was one of relative calm -- short memories again. In addition, they found that the recent experience is extreme in the sense that there has been an increased incidence of forecast errors for real exchange rates of more than two standard deviations. One feature of our current condition is the macro-economic environment. Over the past fifty years, there have been three periods in which there has been a profound slowdown, but in no case a reduction, in global economic growth 1974-75, 1981-82, and 1998-99. Note that all three episodes have been in the last 25 years. Based on projections for 1999, the current period is marginally the second worst in terms of real GDP with annual average growth of 2.4 percent compared with 2.5 percent in 1974-75 and 1.0 percent in 1981-82. Excluding the United States, the differentiation is more pronounced: 2.1 percent growth projected for 1998-99, compared with 3.4 percent in 1974-75 and 1.3 percent in 1981-82. There are at least two important differences in the current period. First, the global inflation rate (consumer prices) is around 6 percent compared with 15 percent in the previous two episodes. Second, the volume of international trade is projected to continue to increase, albeit at a slower than normal rate of 3-3/4 percent, in contrast to small contractions that were experienced earlier. This different macroeconomic environment may have something to do with propagation mechanisms in the current episode, as well as with policy decisions, right or wrong, by national or international authorities. In particular, we have seen a profound, but not a record, downward adjustment in commodity prices. This brings me to contagion, which might more appropriately be called propagation, because the phenomenon at one level is merely the manifestation of the integration of the international economy. Positive linkages are associated with positive, though dated terms, like ”locomotives,” while negative linkages are associated with disease. What we know is that many linkages are real: When the Thai baht depreciated in the summer of 1997, it placed downward pressure on the currencies of Thailand’s neighbors because they jointly competed in each others’ and third-country markets. For a similar reason, the U.S. dollar came under downward pressure during the Mexican peso crisis of 1995. Moreover, the Russian episode last summer can be viewed, at least in part, as a consequence of the global decline in commodity prices associated with the global growth recession. It is a natural consequence of the emergence of problems in one country that international portfolio mangers reassess the risks in their portfolios associated with assets in, or direct and indirect claims on, other countries. This is what financial supervisors want: risk management systems that are continuously stress tested in the laboratory and, preferably in a small way, in the real world. What bothers us, I think, is the appearance of a herd mentality and phenomenon such as proxy hedges, for example, sales of Mexican pesos as a hedge against the depreciation of the Brazilian real because it is easier to short the peso that to short the real. The interesting question in this connection is whether the fault lies in Brazil, in Mexico, or in the functioning of the system as a whole. Again Lewis Alexander and his colleagues have done some interesting analysis and have found that the degree to which volatility in emerging markets spilled over to U.S. financial markets has varied during the 1990s. There was essentially no spillover following the Mexican devaluation in December 1994, perhaps, because the crisis was addressed rather quickly and the principal effects were felt on the U.S. economy and financial system which were and are relatively robust. Following Hong Kong’s interest rate spike in October 1997, there apparently was modest spillover, though it enlivened the day, October 23, 1997, that two other Yale PhDs and I spent with Jim Tobin in Springfield, Illinois at a World Affairs Council conference. Finally, there were very substantial spillovers following the Russian default and devaluation in August of 1998. In that case, the shock to the system may have had more to do with the political dimension of political economy than the economic dimension. It is useful to reflect for a moment on the recent sequence of crises. It is fair to consider them to be individual country crises with international linkages and some common features, but also with important individual characteristics. In the case of Thailand and Korea, the root cause of their crises, I think, lay in macroeconomic policy miscalculations. In both cases, the central banks ran out of foreign exchange, just as Mexico did in 1994. If one includes debt management, including asset management, as one of the dimensions of macroeconomic policy, which seems reasonable especially when a country has a fixed exchange rate regime, then these were crises brought about by failures in macroeconomic policy, even though there were other ingredients present, very weak financial systems in particular. Indonesia is a more difficult case from a macroeconomic perspective because it maintained substantial international reserves throughout the summer and fall of 1997 and its exchange rate was relatively flexible. In retrospect, its exchange rate regime was not flexible enough ex ante, and, ex post, private sector Indonesian borrowers (and implicitly their creditors) found themselves with large unhedged foreign exchange exposures. However, in Indonesia most of the errors in macroeconomic policy came after the crisis hit as the authorities were unable or unwilling to implement a credible, consistent monetary policy. The Philippines is an interesting case precisely because it has been relatively unscathed to date, but its currency did depreciate sharply. Malaysia is also an interesting case because it has chosen to go the non-IMF route and last fall repegged its exchange rate (to the dollar!) and imposed controls on capital outflows. The jury is still out on the Malaysian experience, but it is important to remember three characteristics: First, Malaysia was relatively well positioned in terms of reserves and external debt when Thailand devalued. Second, Malaysia did allow the ringgit to depreciate sharply, indeed, one could make the case that it repegged its currency at an overly depreciated rate. Third, the controls on capital outflows were only imposed 14 months after the baht was floated, which hardly proves that they would have been effective if they had been imposed in July 1997. Moreover, since the imposition of those controls, which are intended to be temporary, the Malaysian authorities have moved relatively aggressively to restructure their domestic banking system. In other words, the controls have not been a device to slow down economic reform. The scale of external adjustment in the Asian economies has been remarkable, and perhaps unprecedented. In Thailand and Korea, swings in current account balances scaled by GDP between 1996 and 1998 were 20 and 18 percent respectively: real GDP contracted about 8 ad 6 percent. These adjustments are difficult for macroeconomists to explain because we do not find it easy to contemplate declines in gross investment ratios of 10 percent of GDP, combined with increases in gross savings ratios of 4 and 7 percent of GDP, as was the case in these two countries. Malaysia had a current account swing of 14 percent of GDP between 1996 and 1998, real GDP declined almost 7 percent in 1998, and there, too, the gross savings ratio rose. In Indonesia, the swing in the external balance was 7-1/2 percent, real GDP declined last year by 15 percent, and the gross savings ratio declined. The Philippines experienced the smallest external adjustment of the five countries between 1996 and 1998 and the smallest decline in real GDP, estimated at only1/2 percent. I run through these data in part because I think they illustrate the point that economists have a lot to learn from and about the macroeconomic characteristics of these episodes. I have already commented on the Russian situation. It had all the ingredients of a classic situation: a large fiscal deficit, mounting external debts, a fixed exchange rate regime, and declining international reserves. Nevertheless, the crisis might not have come in August of 1998, if the global macroeconomic environment had been less unfavorable. It is conceivable that the crisis could have been avoided entirely if the Russian authorities had more time to promote fundamental economic reform, but we will never know. A more convincing case for potential crisis avoidance is Brazil: Absent the global economic slowdown of the dimension that has occurred and absent the Russian crisis, that country’s obvious fiscal vulnerabilities might have been overcome with time and the Brazilian authorities might have been able to adjust their exchange rate regime more gradually. However, one should also note that the government had an opportunity to act decisively in 1997, and they started to do so, but did not follow through on their good intentions. The lesson that I draw from the experience of the past two years is that macroeconomic policies (monetary, fiscal, exchange rate and debt management policies) do matter, which is not to say that they are the whole story, but they are a large part of it. Moreover, as Bill Brainard taught us more than thirty years ago, macroeconomic policy making involves decision making under uncertainty. In an uncertain world, vulnerabilities will come to the surface. Thus, policy makers have an obligation to stress test their policies, their financial systems, and their exchange rate regimes. It is useful to consider the impact of the crises in the Asian economies and the global economic slowdown on countries that were not as severely affected. Consider Australia and Japan. Australia was more directly and adversely affected by collapsing Asian export markets and the decline in commodity prices. Both countries had flexible exchange rate regimes. Both currencies depreciated by about 5 percent in real effective terms [JP Morgan index] between June and December 1997. However, real GDP increased 4.7 percent in Australia over the four quarters of 1998 and declined 3 percent in Japan. What is the explanation for this difference? I am sure there are many, including the weakened condition of the Japanese economy and financial system as of the middle of 1997, but one principal difference is that in Australia there was scope to adjust monetary policy, and three-month interest rates declined by about 100 basis points between June and September, continuing a decline that began in late 1996, while in Japan there was little scope to adjust monetary policy further because three-month interest rates were already hovering around 30 basis points when the crisis broke. It is also interesting, though perhaps a bit unfair, to compare Australia and Hong Kong, countries with two different exchange rate regimes. In Hong Kong, interest rates were not free to adjust because of their currency board system and the added pressure on the Hong Kong dollar’s peg. In part as a consequence, real GDP is estimated to have declined 5 percent last year in Hong Kong and is generally projected to decline further in 1999. All this suggests additional grist for the PhD mills. I would like to conclude with a few comments about international financial architecture. First, reform of the international financial system in the midst of an extended period of turmoil and a sequence of crises is a challenging endeavor. We are simultaneously trying to deal with the ongoing situation, to learn the lessons from that experience, and to lay the groundwork for a more resilient international financial system for the future. Second, as I hope I have illustrated, macroeconomic policies matter. In particular, exchange rate policies and regimes matter. Informed opinion appears to be gravitating to the view that economies can only find sustainable regimes at the two extremes: floating rates or credible pegs with the latter preferably reinforced by currency boards, if not by the appropriation of another country’s currency -- dollarization. What is true, I believe, is that a credible peg in today’s integrated world economy and financial markets requires more discipline over policies, certainly macroeconomic policies and probably domestic financial policies as well, than used to be the case. What is less clear to me is whether a country can effectively operate a regime in which it has a stable but adjustable exchange rate peg. A third, related issue is the organization or lack of organization of international capital flows. It is fashionable in some parts of Asia and some parts of Washington, to blame the so-called Asian financial crisis on irrational capital flows and hedge funds. As someone who studied and taught at Yale in the 1960s and early 1970s, this explanation reminds me of the blame for the exchange rate crises during that period that was placed on the Euro-dollar market, footloose capital flows and the gnomes of Zurich. History repeats itself, it is true; markets do not allocate capital perfectly; and these are important matters. But the core issue, I believe, is not whether we should seek to manage capitals flows, it is whether we can assist markets to perform better with fewer crises, for example via increased transparency and disclosure, strengthened risk management systems in originating countries, and more robust financial systems in destination countries, in other words through prevention. Fourth is the contentious issue of the role of the private sector, and associated concerns about moral hazard for creditors and debtors, when the inevitable crises occur. On this issue, as well as all other aspects of the international financial architecture, there are no silver bullets. If there were, we would have found and used them long ago. However, there is room for improvement as well as the need to strike the right balance, which very well may differ from case to case. A few thoughts on this issue, by way of conclusion:
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