Corral the Biannual Crises

We are watching the third international financial crisis in six years: the collapse of the European monetary system in 1992, the unpleasantness surrounding the Mexican peso in 1994 and now the East Asian financial chaos. The International Monetary Fund reforms for East Asia are moving in the right direction. But what should we have done differently?

At the root of the crisis in Mexico in 1994 and East Asia in 1997 was a sudden change of heart on the part of investors in the world economy’s industrial core--in New York, Frankfurt, London and Tokyo. In Mexico in 1993, international investors poured $25 billion into the economy. In 1995--even though the peso had been devalued by two-thirds and every piece of property and every business in Mexico was thus three times cheaper--international investors took perhaps $10 billion out of the country.

In East Asia in 1996, international investors poured perhaps $100 billion into the region’s economies. In 1998--even though East Asian currencies have been lowered far enough to create some equally amazing bargains for those seeking long-term investments--we will be lucky if the net private capital flow is zero.

At the time, the flood of capital out of Mexico was blamed on guerrilla uprisings in the southern Mexico, the lack of democracy, government corruption and the absence of secure law and order. In East Asia, it is blamed on crony capitalism, official corruption, overextended banks and an absence of honest and trustworthy corporate and government accounts. But Mexico’s ruling party was just as undemocratic when capital was flowing. High-level corruption, banks making loans to the politically well-connected, the absence of trustworthy accounts and crony capitalism were as salient and as troubling when Mexico and East Asia were the darlings of the international capital market.

The root cause of the crises is a sudden change in international investors’ opinions. Like a herd of not-very-smart cattle, they all were going one way in 1993 or 1996, and then they turned around. Was the stampede of capital into emerging markets an irrational mania disconnected from fundamentals of profit and business, or is the stampede of capital out an irrational panic? The correct answer is probably “yes”--the market was manic, it is now panicked, and the sudden change in opinion reflects a psychological victory of fear over greed.

So then, shouldn’t we keep such sudden changes of opinion from having destructive effects? Shouldn’t we use capital controls and other devices to keep international flows of investment small, manageable and firmly corralled? The first generation of post-World War II economists would have said “yes.” The second and third generations regretted the fact that capital controls kept people in industrial countries who had money to lend away from people who could make good use of it in developing economies, and noted that capital controls were not working anyway as investors found ways around them. The balance of opinion shifted to the view that whatever reduction in instability capital controls produced was not worth the sacrifice in economic growth.

So now we have all the benefits of free flows of international capital: The ability to borrow abroad kept the Reagan deficits from crushing U.S. economic growth, and has enabled successful emerging market economies to double or triple the speed at which their productivity levels and living standards converge to the industrial core.

But the free flow of financial capital is also giving us a major international financial crisis every two years. So what is to be done? We should do exactly what the IMF is trying to do right now. The rules for how to handle a financial panic were codified 125 years ago by Walter Bagehot, editor of the London Economist. First, in times of panic some central bank or lender-of-last-resort must throw money--not grants, but loans--at the problem. Second, calling for help in a panic must be expensive--governments, banks, businesses that draw on emergency lines of credit to get them through a panic must pay high enough interest to make the experience one that no one would willingly go through again. Third, the rescuers must lend only to solvent institutions and governments that will, if the panic is halted, be able to pay the loan back.

We do not know how to build a better international economic system, so we need to manage this one as prudently as possible.