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East Asia's Crisis and the Limits to Economics

J. Bradford DeLong

For the Economic Sociology list: ECONSOC

October 6, 1998

International investment

In 1996 international investors poured perhaps $100 billion into East Asia. East Asian economies were the darlings of the world capital market: it seemed as if everyone who wanted to lay claim to any financial sophistication was diversifying into these fast-growing economies. In 1998 and 1999 we will be lucky if the balance of capital flows is zero: if money flowing into East Asia from the world economy's industrial core matches money flowing out of it.

Now things could be worse. As of this writing the South Korean and Thai economies appear to be relatively stable, with low inflation rates, interest rates at normal levels, and good prospects for renewed growth in the near future: the low level to which their exchange rates have been pushed by the crisis makes their exports extremely competitive on the world market. But things could be better: the Indonesian and Malaysian economies and polities remain... unstable, to put it politely. The crisis has developed a second epicenter as reform in Russia begins a downward spiral. And investors all over the globe are fleeing from "risky" assets--driving the interest rates on assets like U.S. Treasury bonds way down, but diminishing business access to capital, bankrupting the stray highly-leveraged hedge fund, and placing economic growth in countries like Brazil at grave risk.

In East Asia the sudden shift in international capital flows means that $100 billion a year that had financed investment in East Asia will no longer be there. That $100 billion had financed the employment of 20 million people working in investment industries, who dug sewer lines, built roads, erected buildings, and installed machines as both domestic and foreign investors bet that there was lots of money to be made in East Asia's industrial revolution. Now that $100 billion a year is gone. And with it the jobs of those 20 million people will go too. They will have to find new jobs. As their jobs vanish, while they search for new jobs, and even after they find new jobs they will be very annoyed: we will see just how stable and "harmonious" East Asian political systems truly are.


Financial collapse

But this sudden shift in investment flows has more important consequences than the forthcoming economic migration of 20 million East Asian workers out of investment industries. In order to pay for the investments they had undertaken, international investors traded dollars for local currencies: baht, ringgit, rupiah, pesos, and won. This gave importers in East Asia $100 billion a year more to spend on imports than their economies earned in exports.

This $100 billion a year has also disappeared, leaving demand for dollars by East Asians to finance imports some $100 billion a year higher than the supply of dollars to them earned from exports. Whenever demand is greater than supply prices rise: a rise in the price of dollars is a fall in the value of other currencies, which have fallen--are falling--will fall until the supply and the demand for foreign exchange are brought back into balance.

In the long run (by, say, the year 2000, we hope) the fall in the value of East Asian currencies will bring the supply of and demand for foreign exchange back into balance. Falling exchange rates make East Asian goods more attractive to European and American purchasers, and so exports rise. Falling exchange rates make American and European goods expensive, and so East Asian imports fall.

In the short run, however, falling exchange rates do not directly bring the supply and demand for foreign exchange into balance. A falling exchange rate means (i) that foreigners buy more East Asian goods, yes, but also (ii) that they pay fewer dollars for each good they buy. In the short run of the next year or two the two effects will roughly balance: Europeans and Americans will not have had enough time to change their spending patterns to make (i) outweigh (ii).

Moreover, falling exchange rates in East Asia destroy East Asian firms and banks with dollar liabilities. Anyone who has borrowed in dollars finds the home-currency value of their debt interest and principal rising when the exchange rate falls. Firms and banks that find their rupiah-denominated earnings no longer large enough to pay their dollar-denominated debts shut down. And as some firms and banks shut down, the willingness of people to lend to others drops. Thus in the short run of a year or two falling exchange rates will bring demand and supply of foreign exchange back into balance by creating an East Asian depression.


Policies to handle the crisis

Couldn't governments stop exchange rates from falling? Yes--East Asian governments could stop their exchange rates from falling by raising interest rates to and perhaps beyond sky-high levels. But high interest rates make it unprofitable to invest or build, and so cause an East Asian depression as well. In the short run East Asian governments have been damned if they let exchange rates fall, and damned if they try to keep exchange rates higher by raising interest rates. So they steer between Scylla and Charybdis, hoping to find the course of action that does the least economic damage.

So can anything be done? Yes--and the IMF did it by lending to East Asia. Lending dollars to East Asian countries now will keep their exchange rates from falling as far and their interest rates from rising as high as if the countries were left on their own. With less of a decline in exchange rates, fewer firms and financial institutions with dollar liabilities will go bankrupt. With less of a rise in interest rates, fewer investment and construction projects will be cancelled. The East Asian depression will be smaller than it would be otherwise. But the IMF's resources are limited, and some must be held in reserve against potential catastrophes that have not happened yet. IMF support programs merely provide some reduction in the economic damage inflicted by the shift in patterns of international investment.


Where did this mess come from?

So how did we get into this mess in the first place? Surely some mighty and glaring errors of economic policy must have been committed in order to cause this crisis in East Asia: what were they?

The answer is that there weren't any mighty and glaring errors of economic policy.

Oh, op-ed writers opine about "crony capitalism" and "unsustainable investment" and "weak financial systems" and "overlending." But such factors were no worse in the East Asia of 1997 that suffered such a crisis than in the East Asia of 1990 or 1985 or 1980 or 1975 that did not. And in every year before 1997 those who worried about "overlending" in East Asia were wrong: those who invested in East Asia received enormous profits, as East Asia proved to be the most rapidly-growing and fastest-industrializing region that the world economy had ever seen. It is only the sudden shift in capital flows away from East Asia that makes investment "unsustainable" and financial systems "weak" and lending "excessive."

So what caused the shift in investment patterns? Unfortunately for economists and for economics as a social science, we can't find any cause of the shift in investment patterns that is proportional to the effect. The shift in Wall Street's desires to invest in East Asia appears to have been impelled much more by the trend-chasing and herding instincts of Wall Streeters--a community of people who talk to each other too much, and whose opinions often reflect not judgments about the world but simply guesses about what average opinion expects average opinion to be--than by any transformation in the fundamentals of East Asian economic development.


The limits of economics

And here we have reached the limits of economics. Economists are good at analyzing how asset markets work if they are populated by far-sighted investors with accurate models of the world and long horizons. Economists are even good at pointing out that such asset markets can be subject to multiple equilibria--situations in which it is rational to be optimistic and rational investors are optimistic if they think that everyone else is optimistic, and in which it is rational to be pessimistic and rational investors are pessimistic if they think that everyone else is pessimistic.

But what determines which of these "multiple equilibria" actually happens in the real world? What determines the switch of an economy from one such configuration to another? The transactions that economists analyze are economic transactions: purchases and sales of goods and assets made with an eye toward maximizing wealth or expected utility. But the transactions that determine which equilibrium will match investor expectations are social and psychological transactions: flows of gossip through telephone wires, the spread of rumors, people taking notice of other people's worried frowns or confident expressions--all of this taking place around the globe at the speed of light, as news and information and gossip and rumor propagate through the social network of investors.

And by now we are into social psychology. And here I, as an economist, need to stop. The most important thing that economists need to know for the making of economic policy are rules-of-thumb to guide their understanding of the process of expectations propagation. But that is an are beyond the limits of economics, and about which economists have nothing to say.

Professor of Economics J. Bradford DeLong, 601 Evans, #3880
University of California at Berkeley
Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax

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