Friday, March 26, 2010

1997 Asian Financial Crisis

Thailand isn’t really a small country. It has more citizens than Britain or France; Bangkok is a vast urban nightmare, whose traffic is every bit as bad as legend has it. Still, the world economy is almost inconceivably huge, and in the commercial scheme of things Thailand is pretty marginal. Despite the rapid growth of recent decades, it is still a poor country; all those people have a combined purchasing power no greater than that of the population of Massachusetts. One might have thought that Thai economic affairs, unlike those of an economic behemoth like Japan, were of interest only to the Thais, their immediate neighbors, and those businesses with a direct financial stake in the country.

But the 1997 devaluation of Thailand’s currency, the baht, triggered a financial avalanche that buried much of Asia. The crucial questions are why that happened and, indeed, how it even could have happened. But before we get to why and how, let’s review what the story of Thailand’s boom, its crash, and the spread of that crash across Asia.

The Boom

Thailand was a relative latecomer to the Asian miracle. Traditionally mainly an agricultural exporter, it started to become a major industrial center only in the 1980’s, when foreign firms—especially Japanese—began building plants in the country. But when the economy did take off, it did so very impressively: as peasants moved from the countryside into the new urban jobs, as the good results experienced by the first wave of foreign investors encouraged others to follow, Thailand began growing at 8 percent or more per year. Soon the famed temples of Bangkok lay in the shadow of office and apartment towers; like its neighbors, Thailand became a place where millions of ordinary people were beginning to emerge from desperate poverty into at least the beginnings of a decent life, and where some people were becoming very rich.

Until the early 1990s, most of the investment associated with this growth came from the savings of the Thais themselves: foreign money built the big export factories, but the smaller businesses were financed by local businessmen out of their own savings; the new office and apartment blocks were financed out of the bank deposits of domestic households. In 1991, Thailand’s foreign debt was slightly less than its annual exports—not a trivial ratio, but one that was well within normal bounds of safety. (In the same year Latin American debt averaged 2.7 times exports.)

During the 1990s, however, this financial self-sufficiency began to change. Mainly the push came from outside. The resolution of the Latin debt crisis made investment in the Third World respectable again. The fall of Communism, by diminishing the perceived threat of radical takeover, made investing outside the safety of the Western world seem less risky than before. In the early 1990s interest rates in advanced countries were exceptionally low, because central banks were trying to boot their economies out of a mild recession; many investors went abroad in search of higher yields. Perhaps most crucial of all, investment funds coined a new name for what had previously been called Third World or developing countries: now they were “emerging markets,” the new frontier of financial opportunity.

Investors responded in droves. In 1990 private capital flows to developing countries were $42 billion; official agencies like the IMF and the World Bank were actually financing more investment in the Third World than all private investors combined. By 1997, however, while the flow of official money had actually slowed, private flows had quintupled, to $256 billion. At first most of the money went to Latin America, especially Mexico; but after 1994 it increasingly went to the apparently safer economies of Southeast Asia.

How did the money get from Tokyo or Frankfurt (most of the lending to Asia was Japanese or European—through wisdom or luck, U.S. banks mainly stayed on the sidelines) to Bangkok or Djakarta? What did it do when it got there? Let’s follow the steps.

Start with a typical transaction: a Japanese bank makes a loan to a Thai “finance company,” an institution whose main purpose is to act as a conveyor belt for foreign funds. The finance company now has yen, which it uses to make a loan at a higher interest rate, to a local real estate developer. But the developer wants to borrow baht, not yen, since he must buy land and pay his workers in local currency. So the finance company goes to the foreign exchange market and exchanges its yen for baht.

Now, the foreign exchange market, like other markets, is governed by the law of supply and demand: increase the demand for something, and its price will normally rise. That is, the demand for baht by the finance company will tend to make the baht rise in value against other currencies. But during the boom years Thailand’s central bank was committed to maintaining a stable rate of exchange between the baht and the U.S. dollar. To do this, it would have to offset any increase in the demand for baht by also increasing the supply: selling baht and buying foreign currencies like the dollar or yen. So the indirect result of that initial yen loan would be an increase both in the Bank of Thailand’s reserves of foreign exchange and in the Thai money supply. And there would also be an expansion of credit in the economy—not only the loan directly provided by the finance company but additional credit provided by the banks in which the newly created baht were deposited; and since much of the money lent out would itself end up back in the banks in the form of new deposits, this would finance yet further new loans, and so on, in the classic “money multiplier” process taught in Econ 101.

As more and more loans poured in from abroad, then, the result was a massive expansion of credit, which fueled a wave of new investment. Some of this took the form of actual construction, mainly office and apartment buildings, but there was also a lot of pure speculation, mainly in real estate, but also in stocks. By early 1996 the economies of Southeast Asia were starting to bear a strong familiar resemblance to Japan’s “bubble economy” of the late 1980s.

Why didn’t the monetary authorities put curbs on the speculative boom? The answer is that they tried, but failed. In all the Asian economies, central banks tried to “sterilize” the capital inflows: obliged to sell baht in the foreign exchange market, the Bank of Thailand would try to buy those baht back elsewhere by selling bonds, in effect borrowing back the money it had just printed. But this borrowing drove up local interest rates, making borrowing from overseas even more attractive and pulling in yet more yen and dollars, The effort to sterilize failed: credit just kept on growing.

The only way the central bank could have prevented money and credit from ballooning would have been to stop trying to fix the exchange rate—to have simply let the baht rise. And this is indeed what many Monday-morning quarterbacks now say the Thais should have done. But at the time this seemed like a bad idea: a stronger baht would make Thai exports less competitive on world markets (because wages and other costs would be higher in dollars), and in general the Thais thought that a stable exchange rate was good for business confidence, that they were too small a nation to endure the kind of widely fluctuating exchange rate the United States can live with.

And so the boom was allowed to run its course. Eventually, as the textbook would tell you, the expansion of money and credit was self-limiting. Soaring investment, together with a surge of spending by newly affluent consumers, led to a surge in imports; the booming economy pulled up wages, making Thai exports less competitive (especially because China, an important competitor for Thailand, had devalued its own currency in 1994), so export growth slowed down. The result was a huge trade deficit; instead of feeding domestic money and credit, those foreign-currency loans started paying for imports.

And why not? Some economists argued—just as Mexico’s boosters had argued in the early 1990s—that the trade deficits of Thailand, Malaysia, and Indonesia were a sign not of economic weakness but of economic strength, of markets working the way they were supposed to. To repeat the argument: as a matter of sheer accounting, a country that is attracting net inflows of capital must be running a current account deficit of equal size. So as long as you thought that the capital inflows to Southeast Asia were economically justified, so were the trade deficits. And why wasn’t it reasonable for the world to invest a lot of capital in Southeast Asia, given the region’s record of growth and economic stability? After all, this wasn’t a case of governments on a spending spree: while Malaysia and Indonesia had their share of grandiose public projects, they were being paid for out of current revenue, and budgets were more or less in balance. So these trade deficits were the product of private-sector decisions; why should these decisions be second-guessed?

Still, a growing number of observers started to feel a bit uneasy as the deficits of Thailand and Malaysia grew to 6, 7, 8 percent of GDP—the sorts of numbers Mexico had had before the tequila crisis. The Mexican experience had convinced some of us that international capital flows, even if they represented the undistorted decisions of the private sector, were not necessarily to be trusted; the bullishness of investors about Asian prospects bore a disturbing resemblance to their bullishness about Latin America a couple years earlier. Asian prospects bore a disturbing resemblance to their bullishness about Latin America a couple of years earlier. And the Mexican experience also suggested that a reversal of market sentiment, when it came, would be sharp and hard to deal with.

What we also should have noticed was that the claim that Asian borrowing represented free private-sector decisions was not quite the truth. For Southeast Asia, like Japan in the bubble years, had a moral hazard problem—the problem that would soon be dubbed crony capitalism.

Let’s go back to that Thai finance company, the institution that borrowed the yen that started the whole process of credit expansion. ‘What, exactly, were these finance companies? They were not, as it happens, ordinary banks: by and large they had few if any depositors. Nor were they like Western investment banks, repositories of specialized information that could help direct funds to their most profitable uses. So what was their reason for existence? ‘What did they bring to the table?

The answer, basically, was political connections—often, indeed, the owner of the finance company was a relative of some government official. And so the claim that the decisions about how much to borrow and invest represented private-sector judgments, not to be second-guessed, rang more than a bit hollow. True, loans to finance companies were not subject to the kind of formal guarantees that backed deposits in U.S. savings and loans. But foreign banks that lent money to the minister’s nephew’s finance company can be forgiven for believing that they had a little extra protection, that the minister would find a way to rescue the company if its investments did not work out as planned. And the foreign lenders would have been right: in roughly nine out of ten cases, foreign lenders to finance companies did indeed get bailed out by the Thai government when the crisis came.

Now look at the situation from the point of view of the minister’s nephew, the owner of the finance company. Basically, he was in a position to borrow money at low rates, no questions asked. What, then, could be more natural than to lend that money at a high rate of interest to his friend the real estate developer, whose speculative new office tower just might make a killing—but then again might not. If all went well, fine: both men would have made a lot of money. If things did not turn out as hoped, well, not so terrible: the minister would find a way to save the finance company. Heads the nephew wins, tails the taxpayer loses.

One way or another, similar games were being played in all the countries that would soon be caught up in the crisis. In Indonesia middlemen played less of a role: there the typical dubious transaction was a direct loan from a foreign bank to a company controlled by one of the president’s cronies. (The quintessential example was the loan that broke Hong Kong’s Peregrine Investment Holdings, a loan made directly to Suharto’s daughter’s taxi company.) In Korea the big borrowers were banks effectively controlled by chaebol, the huge conglomerates that have dominated the nation’s economy and—until very recently—its politics. Throughout the region, then, implicit government guarantees were helping underwrite investments that were both riskier and less promising than would have been undertaken without those guarantees adding fuel to what would probably anyway have been an overheated speculative boom.

Given all of this, the development of some kind of crisis was not too surprising. Some of us can even claim to have predicted currency crises more than a year in advance. But nobody realized just how severe the crisis would be.

July 2

During 1996 and the first half of 1997 the credit machine that had created Thailand’s boom began to slip into reverse. Partly this was because of external events: markets for some of Thailand’s exports went soft, a depreciation of Japan’s yen made Southeast Asian industry a bit less competitive. Mostly, though, it was simply a matter of the house beating the gamblers which in the long run it always does: a growing number of the speculative investments that had been financed, directly or indirectly, by cheap foreign loans went sour. Some speculators went bust; some finance companies went out of business. And foreign lenders became increasingly reluctant to lend any more money.

This was to a certain extent a self-reinforcing process. As long as real estate prices and stock markets were booming, even questionable investments tended to look good. As the air began to go out of the bubble, losses began to mount, further reducing confidence and causing the supply of fresh loans to shrink even more. Even before the July 2 crisis, land and stocks had fallen a long way from their peaks.

The slowdown in foreign borrowing also posed problems for the central bank. With fewer yen and dollars coming in, the demand for baht on the foreign exchange market declined; meanwhile, the need to change baht into foreign currencies to pay for imports continued unabated. In order to keep the value of the baht from declining, the Bank of Thailand therefore had to do the opposite of what it had done when capital starting coming in: it came into the market to exchange dollars and yen for baht, supporting its own currency. But there is an important difference between trying to keep your currency down and trying to keep it up: the Bank of Thailand can increase the supply of baht as much as it likes, because it can simply print them; but it cannot print dollars. So there was a limit on its ability to keep the baht up: sooner or later it would run out of reserves.

The only way to sustain the value of the currency would have been to reduce the number of baht in circulation, driving up interest rates and thus making it attractive once again to borrow dollars to reinvest in baht. But this posed problems of a different sort. As the investment boom sputtered out, the Thai economy had slowed—there was less construction activity, which meant fewer jobs, which meant lower income, which meant layoffs in the rest of the economy—not quite a full-fledged recession, but still the economy was no longer living in the style to which it had become accustomed. To raise interest rates would be to discourage investment further, and perhaps push the economy into an unambiguous slump.

The alternative was to let the currency go: to stop buying baht, and let the exchange rate slide. But this too was an awkward answer, not only because such a devaluation of the currency would hurt the government’s reputation but because so many banks, finance companies, and other Thai businesses now had debts in dollars; if the value of the dollar in terms of baht were to increase, many of them would find themselves insolvent.

And so the Thai government dithered. It was not willing to let the baht fall; nor was it willing to take the kind of harsh domestic measures that would have stemmed the loss in reserves. Instead, it played a waiting game, apparently hoping that something would eventually turn up.

All of this was according to the standard script: it was the classic lead-in to a currency crisis, of the kind that economists love to model—and speculators love to provoke. As it became clear that the government did not have the stomach to turn the screws on the domestic economy, it became increasingly likely that eventually the baht would be allowed to fall in value. But since it hadn’t happened yet, there was still time to take advantage of the prospective event. As long as the baht-dollar exchange rate seemed likely to remain stable, the fact that interest rates in Thailand were several points higher than in the United States provided an incentive to borrow in dollars, and lend in baht. But once it became a high probability that the baht would soon be devalued, the incentive was to go the other way—to borrow in baht, expecting that the dollar value of these debts would soon be reduced, and acquire dollars, expecting that the baht value of these assets would soon increase. Local businessmen borrowed in baht and paid off their dollar loans; wealthy Thais sold their holdings of government debt and bought U.S. Treasury bills; and last but not least, some large international hedge funds began borrowing baht and converting the proceeds into dollars.

All of these actions involved selling baht and buying other currencies; which meant that they all required the central bank to buy even more baht to keep the currency from falling, and depleted its reserves of foreign exchange even faster—which further reinforced the conviction that the baht was going to be devalued sooner rather than later. A classic currency crisis was in full swing.

Any money doctor can tell you that once things have reached that point the government must move decisively, one way or the other: either make a clear commitment to defend the currency at all costs, or let it go. But governments usually have a hard time making either decision. Like many governments before and no doubt many to come, Thailand’s waited as its reserves ran down; lying to convince markets that its position was stronger than it was, it made those reserves look larger through unannounced “currency swaps” (in effect, borrowing dollars now for repayment later). But though the pressure sometimes seemed to abate, it always resumed. By the beginning of July, it was clear that the game was up. On July 2, the Thais let the baht go.

Up to this point, nothing all that surprising had happened. The rundown of reserves, the speculative attack on an obviously weak currency, were right out of the textbooks. But despite the recent experience of the tequila crisis, most people thought that the devaluation of the baht would pretty much end the story: a humiliation for the government, perhaps a nasty shock for some overstretched businesses, but nothing catastrophic. Surely Thailand looked nothing like Mexico. Nobody could accuse it of having achieved “stabilization, reform, and no growth”; there was no Thai Cárdenas, waiting in the wings to enforce a populist program. And so there would not be a devastating recession.

We were wrong.


There are two somewhat different questions to ask about the recession that spread across Asia in the wake of the Thai devaluation. The first is one of mechanics: how did this slump happen? Why should a devaluation in one small economy have provoked a collapse of investment and output across so wide an area? The other, in a way deeper, question is why governments did not, perhaps could not, prevent the catastrophe. What happened to macroeconomic policy?

That second question will take some time to answer, at least partly because it is a matter of very sharp disagreement among reasonable people. So let’s leave it until the next chapter, and simply try to describe what happened.

‘When all goes well, nothing terrible happens when a currency is allowed to drop in value. When Britain abandoned its defense of the pound in 1992, the currency dropped about 15 percent, then stabilized: investors figured that the worst was over, that the lower currency would help the country’s exports, and that it was therefore a better place to invest than it had been before. Typical calculations suggested that the baht would have to fall something like 15 percent to make Thai industry cost-competitive again, so a decline of roughly that magnitude seemed likely. But instead, the currency went into free fall: the baht price of a dollar soared 50 percent over the next few months, and would have risen even further if Thailand had not sharply raised interest rates.

Why did the baht fall so far? The short answer is “panic”; but there are panics and panics. Which was it?

Sometimes a panic is just a panic: an irrational reaction on the part of investors that is not justified by the actual news. An example might be the brief plunge in the dollar in 1981, after a deranged gunman wounded Ronald Reagan. It was a shocking event; but even if Reagan had died, the stability of the U.S. government and the continuity of its policy could hardly have been affected. Those who kept their heads and did not flee the dollar were rewarded for their cool heads.

Much more important in economics, however, are panics that, whatever sets them off, validate themselves because the panic itself makes panic justified. The classic example is a bank run: when all of a bank’s depositors try to withdraw their money at once, the bank is forced to sell its assets at distress prices, causing it to go bankrupt; those depositors who did not panic end up worse off than those who did. And indeed there were some bank runs in Thailand, and even more in Indonesia. But to focus only on these bank runs would be to take the metaphor too literally. What really happened was a circular process—a devastating feedback loop—of financial deterioration and declining confidence, of which conventional bank runs were only one aspect.

The accompanying figure illustrates this process, which occurred in some version in all of the afflicted Asian economies, schematically. Start anywhere in the circle—say, with a decline of confidence in Thailand’s currency and economy. This decline in confidence would make investors, both domestic and foreign, want to pull their money out of the country. Other things being the same, this would cause the baht to plunge in value. Since the Thai central bank could no longer support the value of its currency by buying it on the foreign exchange market (because it no longer had dollars or yen to spend), the only way it could limit the currency’s decline was to raise interest rates and pull baht out of circulation. Unfortunately, both the decline in the currency’s value and the rise in interest rates created financial problems for businesses, both financial institutions and other companies. On one side, many of them had dollar debts, which became harder to service as interest rates soared. And the combination of higher interest rates and troubled balance sheets with a banking system that often found itself unable to make even the safest of loans meant that companies had to slash spending, causing a recession, which in turn meant still worse news for profits and balance sheets. All this bad news from the economy, inevitably, reduced confidence still further—and the economy went into a meltdown.

Leaving aside all the complicated details (which are still being picked over by researchers), this story seems fairly straightforward especially because something quite similar happened in Mexico in 1995. So why did the disastrous effects of Thailand’s devaluation come as such a surprise? The basic answer is that while many economists were aware of the elements of this story—everyone understood that the feedback from confidence, to financial markets, to the real economy, and back again to confidence existed in principle—nobody realized just how powerful that feedback process would be in practice. And as a result nobody realized how explosive the circular logic of crisis could be.

Here’s a parallel. A microphone in an auditorium always generates a feedback loop: sounds picked up by the microphone are amplified by the loudspeakers; the output from the speakers is itself picked up by the microphone; and so on. But as long as the room isn’t too echoey and the gain isn’t too high, this is a “damped” process, and poses no problem. Turn the dial a little too far to the right, however, and the process becomes explosive: any little sound is picked up, amplified, picked up again, and suddenly there is an earsplitting screech. What matters, in other words, is not just the qualitative fact of feedback, but its quantitative strength; what caught everyone by surprise was the discovery that the dial was in fact turned up so high.

Indeed, even now there are many people who find it hard to believe that a market economy can really be that unstable, that the feedbacks illustrated in the figure can really be strong enough to create an explosive crisis. But they are—as we can see by looking at the way the crisis spread.


There is probably a good reason why important meetings about international finance, especially about international crisis management, tend to take place in rustic resorts—why the postwar monetary system was hammered out at the Mount Washington Hotel at Bretton Woods, why many of the world’s finance ministers and central bankers gather each summer at Jackson Lake Lodge in Wyoming. Perhaps the setting helps important people get away from the firefighting of their daily lives, and focus at least briefly on the larger issues. In any case, in early October 1997—when the Asian crisis was well underway, but its severity was not yet clear—a number of bankers, officials, and economists converged on Woodstock, Vermont, to take stock.

By then Thailand was already pretty clearly in deep trouble; the currency of its neighbor Malaysia had also been battered; and the Indonesian rupiah had depreciated about 30 percent. The general sense in the room was that Thailand had brought its woes on itself; and there was little sympathy for Malaysia, which like Thailand had been running huge current account deficits in the past several years, and whose prime minister had clearly made things worse with his denunciations of evil speculators. But everyone agreed that while Indonesia had been right to let its currency slide—indeed, many good things were said about Indonesia’s economic management, the rupiah’s weakness was not really justified. After all, Indonesia’s current account deficits had been nowhere near as large relative to GDP as its neighbors’—at less than 4 percent of GDP, Indonesia’s 1996 deficit was actually smaller than, say, Australia’s. The country’s export base—part raw materials, part labor-intensive manufacturing looked solid; and in general the economy looked fundamentally sound.

Within three months Indonesia was in even worse shape than the rest of Southeast Asia, indeed on its way to one of the worst economic slumps in world history; and the crisis had spread not just across Southeast Asia but all the way to South Korea, a faraway economy whose GDP was twice as large as that of Indonesia, three times as large as that of Thailand. There are sometimes good reasons for economic contagion. An old line says that when the United States sneezes, Canada catches cold; no wonder, when much of Canada’s production is sold in the markets of its giant southern neighbor. And there were some direct links among the afflicted Asian economies:

Thailand is a market for Malaysian products and vice versa. A bit of extra traction may have been generated by the tendency of the Asian economies to sell similar products to third parties: when Thailand devalued its currency, the clothing it exports to the West got cheaper, and therefore cut into the profit margins of Indonesian producers of similar items.

But all estimates of this direct, “goods market” spillover among the crisis economies indicate that it just can’t have been a major factor in the spread of the crisis. In particular, Thailand’s role either as a market for or competitor of South Korea was little more than rounding error for the far larger Korean economy.

A more potent source of contagion may have been more or less direct financial linkage. Not that Thais were big investors in Korea, or Koreans in Thailand; but the flows of money into the region were often channeled through “emerging market funds” that lumped all the countries together. ‘When bad news came in from Thailand, money flowed out of these funds, and hence out of all the countries in the region.

Even more important than this mechanical linkage, however, was the way that Asian economies were associated in the minds of investors. The appetite of investors for the region had been fed by the perception of a shared “Asian miracle”; when one country’s economy turned out not to be all that miraculous after all, it shook faith in all the others. The wise men at Woodstock may have regarded Indonesia as quite different from Thailand, but the investor in the street was less sure arid began to pull back just in case.

And it turned out that whatever the differences among all those economies, one thing they did have in common was susceptibility to self-validating panic. The wise men at Woodstock were wrong about Indonesia, and the panicky investors right; this was not because the wise men had misjudged Indonesia’s virtues but because they had underestimated its vulnerability. In Malaysia, in Indonesia, in Korea, as in Thailand, the market’s loss of confidence started a vicious circle of financial and economic collapse. It did not matter that these economies were only modestly linked in terms of physical flows of goods. They were linked in the minds of investors, who regarded the troubles of one Asian economy as bad news about the others; and when an economy is vulnerable to self-validating panic, believing makes it so.

Why Asia? Why 1997?

Why did Asia experience a terrible economic crisis, and why did it begin in 1997? As Bill Clinton might put it, the answer depends on what you mean by “why.” You might be asking about the specific precipitating events; or you might, more important, be asking about the source of Asia’s extraordinary vulnerability.

If you insist on placing the blame for the onset of the Asian crisis on some specific event, there is a list of usual suspects. One is the exchange rate between the yen and the dollar: between 1995 and 1997 the yen, which had rather mysteriously gone to sky-high levels, fell back to earth. Since most Asian currencies were more or less pegged to the dollar, this made their exports look more expensive both in Japanese markets and in competition with Japanese products elsewhere, contributing to an export slowdown. China’s 1994 devaluation, and more broadly growing competition from China’s cheap labor, likewise cut into Thai and Malaysian exports. And there was a worldwide slump in the demand for electronics in general and semiconductors in particular, an area in which Asia’s economies had tended to specialize.

But Asia had shrugged off much bigger shocks before. The 1985 crash in oil prices, for example, was a major blow to oil-exporting Indonesia; yet the economy grew right through the bad news. The 1990—91 recession, which was not very severe but affected much of the industrial world, reduced the demand for Asia’s exports but did not slow the region’s momentum at all. So the important question is what had changed about Asia (or perhaps the world), so that these pieces of bad news triggered an economic avalanche.

Some of the Asians, notably Malaysia’s Prime Minister Mahathir, had a ready answer: conspiracy. Mahathir, indeed, argued not only that the panic in Asia was deliberately engineered by big financial operators like George Soros but that Soros himself was acting on instructions from the U.S. government, which wanted to cut assertive Asians down to size. As time has gone by, Mahathir’s demonization of hedge funds has started to look a bit less silly than it did when he first began his ranting. But that role became important mainly in 1998 (by which time, incidentally, the activities of Soros and others were very much contrary to U.S. policy wishes); as a story about how the crisis began, conspiracy theory doesn’t wash.

On the other side, many Westerners have turned the story of Asia’s crash into a sort of morality play, in which the economies received their inevital1e punishment for the sins of crony capitalism. After the catastrophe, everyone had a story about the excesses and corruption of the region—about those finance companies, about Malaysia’s grandiose plans for a “technology corridor,” about the fortunes made by Suharto’s family, bout the bizarre diversification of Korean conglomerates (did you hear the one about the underwear company that bought a ski resort, and eventually had to sell it to Michael Jackson?). But this morality play is problematic on at least two counts.

First, while cronyism and corruption were very real in Asia, they were nothing new. Korea’s chaebol were essentially family enterprises disguised as modern corporations, whose owners had been accustomed to special treatment—preferred access to credit, to import licenses, to government subsidies—for decades. And those were decades of spectacular economic growth. It was not a pretty system by Western standards; but it did function very well for thirty-five years. The same may be said, to, a lesser extent, of all the countries caught up in the crisis. Why did their flaws become crucial only in 1997?

And a related point: if the crisis was a punishment for the sins of the Asian economies, how was it that economies that were by no means equally far down the path of development all hit the wall at the same time? Korea in 1997 was not far short of being a developed nation, with per capita income comparable to that of southern European countries; Indonesia was still a very poor country, where progress could be measured in terms of how many calories a day people managed to consume. How is it that such an ill-matched pair could simultaneously be plunged into crisis?

The only answer that makes sense to me, at least, is that the crisis was not (mainly) a punishment for sins. There were real failings in these economies, but the main failing was a vulnerability to self-fulfilling panic.

Back to bank runs: in 1931, about half the banks in the United States failed. These banks were not all alike. Some were very badly run; some took excessive risks, even given what they knew before 1929; others were reasonably well, even conservatively managed. But when panic spread across the land, and depositors everywhere wanted their money immediately, none of this mattered: only banks that had been extremely conservative, that had kept what in normal times would be an excessively large share of their deposits in cash, survived. Similarly, Thailand had a badly run economy, that had borrowed far too much and invested it in very dubious projects; Indonesia, for all its corruption, was much less culpable, and truly had the virtues those wise men imagined; but in the panic those distinctions did not matter.

Were the Asian economies more vulnerable to financial panic in 1997 than they had been, say, five or ten years before? Yes, surely—but not because of crony capitalism, or indeed what would usually be considered bad government policies.

Rather, they had become more vulnerable partly because they had opened up their financial markets—because they had, in fact, become better free-market economies, not worse. And they had also grown vulnerable because they had taken advantage of their new popularity with international lenders to run up substantial debts to the outside world. These debts intensified the feedback from loss of confidence to financial collapse and back again, making the vicious circle of crisis more intense. It wasn’t that the money was badly spent; some of it was, some of it wasn’t. It was that the new debts, unlike the old ones, were in dollars — and that turned out to the economies’ undoing.

- Paul Krugman

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