Financial Panic and the Law of Unintended Conseque

CAMBRIDGE: One oft-repeated lesson of public policy is the Law of Unintended Consequences. A policy is adopted to "fix" one problem, only to create another problem, sometimes one much worse than the original. The closer you examine the financial crises that hit East Asia, Eastern Europe, and Latin America over the past two years, the more these events look to be almost definitive proof of the Law of Unintended Consequences.

Although each regional crisis has been blamed on mismanagement by governments in the developing world, much of the blame -- perhaps most -- actually lies in the advanced countries. More precisely, banking regulation in the advanced countries may have precipitated financial crisis across the developing and postcommunist world.

The essence of the recent financial crisis is that international bank loans flew into the "emerging markets" during the years 1993-96, only to flee these same markets in 1997 and after. Countries like Russia, or Indonesia, Korea, and Thailand in East Asia, or Brazil and Peru in Latin America, were able to borrow on easy conditions in the mid-1990s, but then faced a panicked withdrawal of loans in the past two years.

The reversal of bank lending is staggering. According to recent data prepared by the investment bank J. P. Morgan, international banks lent the 25 main emerging markets a total of $100 billion in net loans (that is, loans minus repayments) in 1995, $121 billion in 1996, and $46 billion in 1997, only to demand net repayments of $95 billion in 1998. In emerging Asia, the swing was the worst: from $81 billion in loans 1996 to $84 billion in net repayments in 1998.