The East Asian Crisis: What Next?

Cambridge: The Asian crisis has now passed more than one half year. We can better see what caused the crisis, what has worked in responding to the crisis, what has not worked, and what now needs to be done.

The immediate cause of the crisis is clear: a sudden, unexpected, and large-scale reversal of international capital flows into Asia. During 1996, foreign investors put $93 billion into the five Asian countries now in crisis (Indonesia, Korea, Malaysia, Philippines, and Thailand). This followed new inflows of $47 billion in 1994, and $70 billion in 1995. In 1997, the investors panicked, withdrawing $12 billion instead of making new investments. The swing of $105 billion (from inflow of $93 billion to outflow of $12 billion) equaled about 11 percent of the pre-crisis national incomes of these countries. A collapse of 11 percent of national income in investment finance is catastrophic: it has thrown these countries into deep recession.

Pundits like to blame "Asian capitalism" for the crisis — an alleged orgy of corruption, nepotism, government meddling, and poor financial supervision. This explanation is convenient to European and U.S. banks because it gets them off the hook. But it is not exactly true. If Asian capitalism is so bad, why did foreign investors put so much money into Asia in the first place? A better explanation for the crisis is that investors panicked. They were perhaps too euphoric in 1996, but then wildly pessimistic in 1997. But once the investors started to flee from Asia, it became individually rational for each particular investor to get out, even if the result was a ruinous stampede which hurt both the investors and the Asian economies.

For the first six months of the crisis, the IMF prescribed tough austerity measures to limit the crisis — bank closures, high interest rates, budget surpluses. These measures were misguided, and they failed. Rather than calming the foreign investors, they contributed to the very panic that the IMF was trying to address. Nobody wanted to keep money in a region that suddenly looked like it was heading for disaster. Every IMF forecast therefore failed. The currencies collapsed, and the banking sectors collapsed. The IMF predicted that Thailand and the others would achieve positive growth in 1998 (3 percent in the case of Thailand, for example). Now, the IMF acknowledges that Thailand will shrink by around 3 percent. Its medicine did little to save the economy.