Asia's 'Rational' Panic

CAMBRIDGE: Asia’s financial crisis amazes not only for its ferocity, but for its speedy dismantling of conventional wisdom. Six months ago, Asia’s economies were "miracles." Now, they are "basket cases." Prominent articles ask whether Asia will experience a "lost decade" comparable to Latin America in the 1980s. This new wisdom is not only wrong but dangerous, because it is potentially self-fulfilling.

Financial panic in Asia emerged after years of growth so high and steady that international lenders and domestic borrowers became complacent about financial risks. International banks lent hundreds of billions of dollars to Asian banks and corporations, much on a short-term basis. Borrowing fueled booming investment spending -- some wasteful, but most catalyzing rapid development.

High levels of short-term debt create what economists call "financial fragility." Even if debt levels are tolerable and economies well managed, high short-term debt exposes borrowers to the risk of rapid changes in market sentiment. Short-term loans are tied up in long-term projects. If many investors demand repayment, borrowers have a hard time meeting these demands, even if the long-term projects are sound.

"Rational panic" ensues. Every investor wants to be the first out, because existing short-term assets cannot cover short-term loans. The investors are "rational" individually, but their collective action leads to tragedy. This is the story of recent trouble in Thailand, Indonesia, Malaysia, the Philippines, Korea, and nearly all emerging markets.