Crisis response lessons left unlearned

Policy makers failed to learn from the Asian crisis when responding to the European and American financial dramas, throwing future crisis responses into doubt.

Lowy Interpreter

Do we learn from economic crises? The 2008-10 crises in America and Europe and the Asian crisis a decade earlier present a rich source of contrasting experience to examine.

What a divergence there is between the 2008-10 policy responses and 1997-8! In 1997 IMF funding, even supplemented by additional bilateral rescue funds, was too small to offset the capital outflow that was driving down exchange rates. The Asian crisis countries received support equal to less than 10 per cent of GDP, while in 2010 the European crisis countries received support equal to 50 per cent of their GDP. The Fund component was 800 per cent of IMF quota for the Asians, and 2230 per cent of quota for the Europeans.

The adamant advice on monetary policy in 1997 was to tighten strongly, pushing up interest rates. In 2008, central banks not only pushed interest rates down to zero, but have also spectacularly expanded their balance sheets with innovative support for financial markets.

Swift closure of troubled financial institutions was mandatory practice in Asia. This was supposedly necessary to avoid ‘moral hazard’ from guaranteeing bank depositors or bailing out banks. This concern was forgotten in 2008. It wasn’t just banks that were saved by taxpayers’ support: insurance companies (AIG), the money market and the car industry were all rescued. In Europe, even clearly insolvent countries such as Greece were bailed out.

Fiscal policy was tightened in both episodes, but in 2008 it was because countries were starting with large deficits and unsustainable debt levels, while in 1997 the crisis countries had budget surpluses and low debt. The 1997 tightening was a macro blunder, crunching countries whose output was already in freefall.

How could the prescription be so different?

First, the problem in 1997 was misunderstood by the outsiders who tried to help. At the time, a central role was given to ‘crony capitalism’: Soeharto in Indonesia and the chaebols in Korea.

Now, fifteen years later, the central macro-economic issue can be seen as the sudden reversal of foreign capital, triggered by concerns about over-heating economies, overvalued exchange rates and excessive foreign borrowing, all of which were symptoms of the pre-crisis period of hugely excessive capital inflows. This was a liquidity problem which required the sort of treatment given to the European peripheral countries in 2010. Balance of payments support was needed, foreign debt had to be reduced through rescheduling and banks had to be kept going, not closed.

Policy was also confused by the doctrinal belief that free markets would deliver the right answers. In the middle of the 1997 crisis, the Fund was trying to amend its Articles to give free capital movements the same compulsory status as free trade.

Those involved in 1997 don’t seem to feel at all sheepish about the mistakes made. Many of them are still around (some were at a recent Peterson Institute conference which compared the two crises), and many were involved in both crisis periods. The nearest the IMF has come to a mea culpa is a 2012 speech by David Lipton (now IMF First Deputy Managing Director, but then one of the United States Treasury bovver boys standing over the IMF), where he said that it all worked out for the best, as the result was stronger financial sectors able to withstand the 2008 shock.

Larry Summers, one of the ‘Committee to Save the World' (no, this wasn’t derisory or ironic) has shown more introspection. In 2010, deeply involved in Obama’s response to the 2008 crisis, he said:

“There have been moments, certainly, when I understood better some of the reactions of officials in crisis countries now than one was able to from the outside at the time. It is easier to be for more radical solutions when one lives thousands of miles away than when it is one’s own country.”

It seems that policy-makers have to learn for themselves. No-one in advanced countries thought that the Asian crisis had any lessons for them, even though the pre-crisis circumstances in the European peripheral countries had the same excessive capital inflow, with the same loss of international competitiveness.

When the 2008 crisis unfolded, policy-makers responded with ad hoc common sense rather than by drawing specific lessons from the Asian experience. The IMF has come to understand that foreign capital flows present big macro challenges for emerging countries, and that free-floating exchange rates can fluctuate widely. But this belated recognition came much more recently.

The 1997 crisis countries learned some lessons (which helped them weather 2008), without always finding satisfactory answers. They have taken out expensive self-insurance through big foreign reserves, exacerbating international imbalances in the process. Unhappy with the IMF, they created the Chiang Mai Initiative but have not been able to make it operational (it remained unused in 2008).

Even now, if we ask, “Have the problems been fixed?”, the answer is clearly “no”. We don’t know where or when the next financial crisis will occur, but we can be sure that there will be more.

Originally published by The Lowy Institute publication The Interpreter. Republished with permission.

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