From this confluence of campaign finance, personal connections, and ideology there flowed, in just the past decade, a river of deregulatory policies that is, in hindsight, astonishing:
• insistence on free movement of capital across borders;
• the repeal of Depression-era regulations separating commercial and investment banking;
• a congressional ban on the regulation of credit-default swaps;
• major increases in the amount of leverage allowed to investment banks;
• a light (dare I say invisible?) hand at the Securities and Exchange Commission in its regulatory enforcement;
• an international agreement to allow banks to measure their own riskiness;
• and an intentional failure to update regulations so as to keep up with the tremendous pace of financial innovation.
The mood that accompanied these measures in Washington seemed to swing between nonchalance and outright celebration: finance unleashed, it was thought, would continue to propel the economy to greater heights.
Particularly, that first point. One of the similarities between the last decade and the 1920s that has not been much remarked on in the popular press is the absolute flood of foreign capital that hit Wall Street. From John Kenneth Galbraith's Great Crash:
People were swarming to buy stocks on margin--in other words, to have the increase in the price without the costs of ownership. This cost was being assumed, in the first instance, by the New York banks, but they, in turn, were rapidly become the agents for lenders the country over and even the world around. There is no mystery as to why so many wanted to lend so much in New York. One of the paradoxes of speculation in securities is that the loans that underwrite it are among the safest of all investments. They are protected by stocks which, under all ordinary circumstances, are instantly saleable, and by a cash margin as well. This money, as noted, can be retrieved on demand. At the beginning of 1928 this admirably liquid and exceptionally secure outlet for non-risk capital was paying around 5 per cent. While 5 per cent is an excellent gilt-edged return, the rate rose steadily through 1928, and during the last week of the year it reached 12 per cent. This was still with complete safety.
In Montreal, London, Shanghai and Hong Kong, there was talk of these rates. Everywhere men of means told themselves that 12 per cent was 12 per cent. A great river of gold began to converge on Wall Street to help Americans hold common stocks on margin.
The causes were deeper than that, tracing back to the post-World-War-I exchange rate regime and the deep imbalances of Versailles. In a sense, Galbraith may be confusing cause and effect--the market may have taken off because of stupid money from abroad. But these things feed on themselves, and so it's probably folly to try to separate chicken from egg. The core point is the phenomenon he identifies: foreign money with little local knowledge flooding into the market, helping to run up asset prices to an unsustainable level, and then departing. This is the classic outline of an emerging market crisis, and arguably that's what happened to us, with Asian savings.
Ironically, it may be possible to trace back this flood of money to the IMF--and Timothy Geithner. Just as the gold flows in the 1920s had their roots in Versailles, the flows of Asian money into US dollars are often thought to be an artifact of the 1998 crisis, when hot money suddenly started deserting the region in droves. Asian businesses and central banks became determined that that would never happened again--and the way they opted to prevent it was to amass massive foreign reserves, particularly in dollars.
Paul Keating, the former Australian prime minister who worked with Geithner during the crisis, blames his mishandling of the crisis for this desperate reserve-hoarding:
In a speech to a closed gathering at the Lowy Institute in Sydney on Thursday, Paul Keating gave a starkly different account of Geithner's record in handling the Asian crisis: "Tim Geithner was the Treasury line officer who wrote the IMF [International Monetary Fund] program for Indonesia in 1997-98, which was to apply current account solutions to a capital account crisis."
In other words, Geithner fundamentally misdiagnosed the problem. And his misdiagnosis led to a dreadfully wrong prescription.
Geithner thought Asia's problem was the same as the ones that had shattered Latin America in the 1980s and Mexico in 1994, a classic current account crisis. In this kind of crisis, the central cause is that the government has run impossibly big debts.
The solution? The IMF, the Washington-based emergency lender of last resort, will make loans to keep the country solvent, but on condition the government hacks back its spending. The cure addresses the ailment.
But the Asian crisis was completely different. The Asian governments that went to the IMF for emergency loans - Thailand, South Korea and Indonesia - all had sound public finances.
The problem was not government debt. It was great tsunamis of hot money in the private capital markets. When the wave rushed out, it left a credit drought behind.
But Geithner, through his influence on the IMF, imposed the same cure the IMF had imposed on Latin America and Mexico. It was the wrong cure. Indeed, it only aggravated the problem.
Keating continued: "Soeharto's government delivered 21 years of 7 per cent compound growth. It takes a gigantic fool to mess that up. But the IMF messed it up. The end result was the biggest fall in GDP in the 20th century. That dubious distinction went to Indonesia. And, of course, Soeharto lost power." . . .
Worse, Keating argued, Geithner's misjudgment had done terminal damage to the credibility of the IMF, with seismic geoeconomic consequences: "The IMF is the gun that can't shoot straight. They've been making a mess of things for the last 20-odd years, and the greatest mess they made was in east Asia in 1997-98, so much so that no east Asian state will put its head in the IMF noose."
China, in particular, drew hard conclusions from the IMF's mishandling of the Asian crisis. It decided that it would never allow itself to be dependent on the IMF, or the US, or the West generally, for its international solvency. Instead, it would build the biggest war chest the world had ever seen.
Keating continued: "This has all been noted inside the State Council of China and by the Politburo. And it's one of the reasons, perhaps the principal reason, why convertibility of the renminbi remains off the agenda for China, and it's why through a series of exchange-rate interventions each day that they've built these massive reserves.
"These reserves are so large at $US2 trillion as to equal $US2000 for every Chinese person, and when your consider that the average income of Chinese people is $US4000 to $US5000, it's 50 per cent of their annual income. It's a huge thing for a developing country to not spend its wealth on its own development."
Is this some flight of Keatingesque fancy? The former deputy governor of the Reserve Bank of Australia, Stephen Grenville, doesn't think so: "After the Asian crisis, the countries of east Asia decided that they would never go to the IMF again. The IMF is taboo in east Asia. Look at the evidence. The revealed preference of the region is that no one has gone to the IMF since, even when they needed the money."
To me, this doesn't suggest Geithner or the IMF were incompetence: hindsight is 20/20. What it does suggest is that global capital flows may be way more problematic than I have historically been willing to credit. I don't want to blame all bubbles on foreign money. But foreign money has two unpleasant characteristics: there is so much of it that it can relatively easily swamp a nation's productive capacity, and it is relatively uninformed about the local market.
I'm not sure where that leaves me. The capital controls of the mid-twentieth century were even worse, especially for emerging markets, where they became both focal points for, and sources of, massive corruption. And one of the reasons America today is such a massively successful economy is that foreign money funded our industrialization. Bubbles may simply be an inescapable side effect. But perhaps it's time to rethink a committment to global capital liberalization.
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