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Recovery? Don't Bet on It

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PAUL KRUGMANTwo years ago, a nasty virus emerged in Bangkok. It proved highly contagious, spreading rapidly through Asia and beyond, often claiming seemingly robust economies as victims, and for a while it looked as if it might become a global pandemic. But there have been no new reported cases in the past few months, and most of the original victims seem to be past the worst. And like anyone who has been very sick and starts to feel better, they feel relieved, even euphoric--though they are still a long way from full recovery.

But it's still far too early to break out the champagne. For one thing, Asia's turnaround remains a partial thing. has recovered faster than anywhere else, and its economy might grow as much as 5% this year; yet even if it does, output will still be 14% below the pre-1997 trend line. , whose economy is bigger than that of all the other troubled nations put together, has yet to show any convincing signs of a turnaround, and almost everyone expects the unemployment rate there to keep rising even if GDP stops falling. China has managed to keep growing throughout the crisis, but it is subject to heightening financial strain.

And if the sense of imminent doom that hung over the region last summer has abated, that is not entirely a good thing. For when you come down to it, Asia has not emerged from this crisis with any clear idea about how to avoid the next one. None of the vulnerabilities that made the great Asian crisis of 1997-98 possible has disappeared, and there is every reason to believe that Asia has emerged from the crisis with its long-term prospects far less promising than they had seemed only two years ago.

But let us begin by trying to understand what went wrong in the first place.

The Asian Flu

Pundits who want to sound judicious are fond of warning against generalizing. Each country is different, they say, and no one story fits all of Asia. This is, of course, silly: all of these economies plunged into economic crisis within a few months of each other, so they must have had something in common.

In fact, the logic of catastrophe was pretty much the same in , , and South Korea. (Japan is a very different story.) In each case investors--mainly, but not entirely, foreign banks who had made short-term loans--all tried to pull their money out at the same time. The result was a combined banking and currency crisis: a banking crisis because no bank can convert all its assets into cash on short notice; a currency crisis because panicked investors were trying not only to convert long-term assets into cash, but to convert baht or rupiah into dollars. In the face of the stampede, governments had no good options. If they let their currencies plunge, inflation would soar and companies that had borrowed in dollars would go bankrupt; if they tried to support their currencies by pushing up interest rates, the same firms would probably go bust from the combination of debt burden and recession. In practice, countries split the difference--and paid a heavy price regardless.

Was the crisis a punishment for bad economic management? Like most clichιs, the catchphrase crony capitalism has prospered because it gets at something real: excessively cozy relationships between government and business really did lead to a lot of bad investments. The still primitive financial structure of Asian business--too little equity, too much debt and too much of that debt consisting of soft loans from accommodating banks--also made the economies peculiarly vulnerable to a loss of confidence. But the punishment was surely disproportionate to the crime, and many investments that look foolish in retrospect seemed sensible at the time. After all, suppose that the United States, which currently is pulling in overseas money at the rate of about $300 billion annually, were to see that inflow suddenly become a trillion-dollar outflow (which, relative to the scale of the economy, is what happened to Asia's crisis-hit countries). How solid would America's financial system look?

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Given that there were no good policy options, was the policy response mainly on the right track? There was frantic blame-shifting when everything in Asia seemed to be going wrong; now there is a race to claim credit when some things have started to go right. The International Monetary Fund points to Korea's recovery--and more generally to the fact that the sky didn't fall after all--as proof that its policy recommendations were right. Never mind that other IMF clients have done far worse, and that the economy of Malaysia--which refused IMF help, and horrified respectable opinion by imposing capital controls--also seems to be on the mend. Malaysia's Prime Minister Mahathir Mohamad, by contrast, claims full credit for any good news--even though neighboring economies also seem to have bottomed out.

The truth is that an observer without any ax to grind would probably conclude that none of the policies adopted either on or in defiance of the IMF's advice made much difference either way. Budget policies, interest rate policies, banking reform--whatever countries tried, just about all the capital that could flee, did. And when there was no more money to run, the natural recuperative powers of the economies finally began to prevail. At best, the money doctors who purported to offer cures provided a helpful bedside manner; at worst, they were like medieval physicians who prescribed bleeding as a remedy for all ills.

Will the patients stage a full recovery? As U.S. President Bill Clinton might say, it depends on exactly what you mean by full. South Korea's industrial production is already above its pre-crisis level; but in the spring of 1997 anyone who had predicted zero growth in Korean industry over the next two years would have been regarded as a reckless doomsayer. So if by recovery you mean not just a return to growth, but one that brings the region's performance back to something like what people used to regard as the Asian norm, they have a long way to go--and there are a couple of good reasons to think that they won't get there.

First is what a Thai economist described to me as the decapitation of the entrepreneurial class. Arguably, developing Asia had few true corporations in the Western sense. Institutions that looked, on paper, like modern corporations were really overgrown family firms, whose growth depended on the personal wealth of their owners and their ability to leverage that wealth through bank loans. While some progress has been made on repairing the region's devastated banks, it will be a long time before those banks are either able or willing to provide the kind of funding they used to--and in any case the entrepreneurs, their fortunes slashed by the crisis, cannot provide the necessary collateral. In time, alternatives can be found: economies can grow a new class of entrepreneurs, they can open the door to the expertise and capital of foreign companies, they can reform and modernize their financial systems (including developing workable and enforceable bankruptcy procedures). But for now, and probably for years to come, these economies are likely to remain weakened by their ordeal.

Second, even before the crisis there were indications that Asia was running into diminishing returns--that rapid growth was being sustained only by ever-more massive infusions of capital, much of it from abroad. (My notorious 1994 article in Foreign Affairs, summarized that evidence.) Well, there isn't going to be nearly as much capital available in the future: foreign investors may have stopped fleeing, but they are not going to pour in funds the way they did a few years ago. So while there may be a year or two of growth at something like pre-1997 rates as Asian economies take up some of their slack, the post-crisis trend is probably going to be far below previous expectations.

Could the recovery be aborted, with an actual relapse? At least for the near future a cash squeeze like that of 1997-98 seems hard to envision. Short-term foreign debts have mostly been paid off, and massive trade surpluses--the product of devalued currencies and depressed economies--have allowed the crisis-hit countries to rebuild large reserves of foreign exchange. It would take several years of irresponsible borrowing to create the conditions for a repeat of 1997. As Mexico can attest, such things can be arranged, but the prospect does not seem imminent.

Unfortunately, there still could be a second act to the Asian crisis. That's because some of the players have not yet worked out their problems.

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The Japan Syndrome

Japan was in trouble long before anyone even imagined that the words Asia and crisis could be used in the same sentence. And the good news that has recently started to come in from its neighbors has no counterpart in the island nation, where the best that can be said is that last year's economic plunge has leveled off. If developing Asia suffered from an acute, potentially lethal, but short-lived fever, Japan suffers from a slow wasting disease, one that shows no sign of going into remission.

What is wrong with Japan, the nation that not so long ago seemed to be the heir-apparent to world economic leadership? The inefficiency of Japan's service sector is legendary. Although the country remains a formidable exporter, it has been slow to adopt some new technologies. And like its poorer neighbors, Japan has troubled banks and has been too slow to fix them. But the clear and present constraint on Japan's economy is something that would normally be regarded as a virtue: the caution and thriftiness of its consumers. Japanese households simply save more than the country's businesses can be persuaded to invest, even at near-zero interest rates. The result is that, for the first time since the 1930s, a major economy finds itself in the dreaded liquidity trap, in which the private sector as a whole is in effect trying to accumulate cash. Since this is collectively impossible--there cannot be sales without purchases--the attempted flight to cash produces a persistently depressed economy, one that every year falls further below its productive potential.

Why is Japan in this predicament? Maybe the economy has never recovered from the bursting of the late-'80s financial bubble; maybe Japan's dismal demography (the working-age population peaked in 1997 and is expected to decline steadily for decades to come) is the key. What is clear is that policymakers have not yet found a solution.

The classic prescription for curing a liquidity trap is a fiscal jump-start: use deficit spending to get the economy moving, and hope that this gets investors investing and consumers consuming. But after years of ever-widening deficits--this year Japan will run far and away the largest peacetime budget deficit ever recorded--the economic engine shows no sign of catching, while the government's debt has risen to worrisome levels. Some economists (most obnoxiously, yours truly) have argued that Japan needs to stand the normal rules of monetary policy on their head, abandoning the goal of price stability and actually committing to a moderate rate of inflation (which would make borrowing more attractive, and holding cash less so). But the Bank of Japan remains obdurately orthodox.

At this point the Japanese government still seems to hope that somehow the situation will right itself. Massive public works programs have slowed the rapid economic decline of last year--and helped push growth in this year's first quarter to a surprisingly high annualized rate of 7.9%. But there is no sign of a genuine, self-sustaining recovery, and it is all too easy to see how things could get considerably worse. Indeed, it is alarmingly easy to see how Japan could plunge into a nasty deflationary spiral. Here's that scenario: Japanese companies finally begin rationalizing, that is, laying off large numbers of unneeded workers; fear of unemployment makes cautious consumers even more nervous; declining spending leads to still more unemployment; and a depressed economy leads to falling prices, worsening the debt burden on corporations and making cash an even more attractive asset. And if this nightmare chain of events starts to unfold, it is unclear what Japanese officials could or would do about it. With interest rates near zero, conventional monetary policy is already as expansionary as it can get; with huge government debt and deficits, there isn't much room for another fiscal boost.

Inevitably, worries about Japan color the prospects of the whole region. This is partly because Japan is a major export market, partly because bad news from Japan would surely affect market perceptions of the whole region. But it may also be an omen, for the Japan syndrome need not be confined to Japan.

One might have expected China's economic problems to bear more resemblance to those of other low-wage economies like Indonesia than to those of its far richer and more developed neighbor. But China never caught the Asian flu, because foreign-exchange regulations prevented hot money from leaving and deterred it from coming in the first place. (Although those regulations have also fostered inefficiency and corruption.) If growth has slowed, it is because Chinese consumers--worried about unemployment as Beijing continues to reform the state sector, and about saving for retirement in an aging society (an unanticipated side-effect of the one-child policy)--are not keeping up with productive capacity. Incredibly for a developing country, China is now experiencing pronounced deflation--and is fighting it, Japanese-style, with deficit spending.

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China still has considerable room to maneuver--its interest rates are well above zero, its official budget deficits and debt are still relatively small. But there are, by all accounts, huge hidden liabilities in the form of bankrupt state firms and insolvent banks. In the end China, like Japan, may be forced to roll the printing presses--a move that will not be possible without a devaluation of the renminbi. And that would make the lives of its neighbors, especially , considerably more difficult.

In short, Asia will probably not have the same problems over the next two years that it had over the last two; but it is at considerable risk of having different problems. It ain't over until the sumo wrestler sings.

Lessons

Adversity is supposed to come with a silver lining: it may hurt, but it teaches valuable lessons and forces reform. Has Asia's crisis laid the foundations for sounder economic growth in the future?

The answer is a definite maybe. The crisis has curbed some of the worst abuses of crony capitalism, and it has tempered the dangerous belief that Asian values somehow made the region's economies invulnerable. The crisis has also probably done some good by softening free-market fundamentalism: countries are less likely to be pressured into throwing their capital markets open to the world before their financial markets are ready, and Washington is less likely to view the main purpose of economic diplomacy as being that of making the world safe for hedge funds. And above all, the crisis has reinforced democratic tendencies and made it much harder for paternalistic strongmen to claim that they know best.

Still, it is hard to escape the feeling that a dangerous complacency is setting in. Back in 1996, when Mexico started to recover from its crisis, policymakers and investors alike acted as if that was a one-time event, never to be repeated. But it turned out to be a dress rehearsal for the Asian crisis a year later. Now, because the world didn't end this time around, everyone is starting to believe that we have the situation under control--even though proposals for international reform have been watered down to homeopathic levels. Could investors and countries really be foolish enough to make the same mistakes yet again? Of course they could.

Paul Krugman, a professor of economics at M.I.T., is the author of the new book The Return of Depression Economics (W.W. Norton; 176 pages)
Free Advice


1 Japan should print lots of money and say that a little inflation is probably a good thing. This is no time to worry about respectability

2 When that leads to a weaker yen, the rest of Asia should stay calm, and consider following Japan's lead. Deflation is now a bigger risk than inflation

3 Everyone should keep interest rates low and spend freely. Did I mention that deflation is a serious risk?

4 Push some companies into real bankruptcy and sell the pieces to foreigners

5 Invite foreign banks in

6 Lean on firms that seem to be leveraging themselves up again--especially if the debt is in dollars

7 Admit that Mahathir wasn't all wrong. In a crisis maybe capital controls aren't such a bad idea after all. It will discourage some investors--but you don't want those guys anyway

8 When magazines like this start declaring that Asia is back, just remember how good the press clippings were back in 1996

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