Fixing The Asian Economic Crisis: Plans A, B and C

Keith Rankin, 27 September 1998

Paul Krugman, whose three Robb Lectures (see my comments: 1, 2, 3) in Auckland last month analysed the Asian economic crisis, published at that time an article in Fortune magazine that was reprinted in Time (7 September 1998).

His analysis tells us why the IMF formula (Plan A) did not work (as it appeared to have done in Mexico in 1995, for example), and advocates Plan B, exchange controls, as a case of desperate measures for desperate times.

Krugman summarises Plan A as:

  1. Lend the afflicted countries money to help them tide over the crisis.
  2. As a condition for the loan, demand that they reform their economies....
  3. Require them to maintain high interest rates to entice capital into staying in the country.
  4. Wait for confidence to return...

The central problem is that, interest rates need to be cut rather than raised in order to stimulate a recovery. In the case of Mexico in 1995, recovery (of sorts, with a much more unequal income distribution) took place despite rather than because of high interest rates.

High interest rates are advocated for one reason only; to stem capital flight. Capital flight means, in the context of floating exchange rates and convertible currencies, a form of financial panic where domestic and foreign investors alike sell the currencies of the affected countries in order to avoid capital loss. Foreign currency speculation is all about making capital gains and avoiding capital loss. Speculation grossly accentuates economically-correct currency movements, which are based on trade flows.

Krugman's Plan B, recently adopted by Malaysia, represents the only reactive option available to countries which are experiencing capital flight.

Exchange controls take many forms. They were the norm for most countries before the late 1980s, including New Zealand. One form of controls, which Krugman advocates, is the maintenance of parallel exchange mechanisms: an official rate and a market rate. Exporters sell foreign currency to the government at the official rate. That currency is rationed. Any additional foreign currency requirements must be funded via the market rate, which is determined by sentiment in the international financial markets.

Exchange controls enable governments to cut interest rates - and to create new money - without suffering from the reef fish mentality that characterises speculative international finance. They give the country a stable, if "second best", environment. Krugman clearly sees the crisis environment as a distant third best, thereby justifying a second best option. He believes that the adoption of exchange controls should be a temporary measure.

An associated piece by Time staff writer Jeremy Kahn endorses Krugman's "desperate" Plan B, in part because "no one seems to have a Plan C".

Well I have a Plan C. It should not be thought of as mutually exclusive from Plans A and B. I hinted at this plan in my recent NZ Herald article: "NZ must not go back to capital addiction". Furthermore, President Clinton did follow Plan C towards the end of June this year when the USA acted to halt the depreciation of the Japanese yen.

The key insight is that, for every depreciating currency, there is an appreciating currency. To the extent that the depreciations are inappropriate (ie speculative) then the appreciations are also inappropriate. It is however much easier for the governments of the countries with inappropriately appreciating currencies to deal with the problem.

Countries receiving capital that has flown from the countries perceived to be in crisis are able to print money and deposit that money in accounts denominated in the depreciating currencies. They do so at no cost to themselves, but by doing so they are acting to offset the excessive private capital that they have been receiving. Not only is creating such new money costless to them, but by averting excessive currency appreciation, they save themselves from the consequences of an overvalued exchange rate.

Capital receiving countries that create money and convert it into low demand currencies also save themselves by stabilising the world economy; by preventing these crises of confidence from escalating into worldwide depression. I am reminded of the classic 1932 David Low cartoon, which depicts a sinking boat, with the countries of central Europe in the submerging end of the boat. The leaders of the creditor countries in the dry end of the boat say "it's all right, we don't need to do anything; it's not us who are sinking".

Some will argue that the creation of money within countries whose currencies are in high demand will lead to an inflationary global environment. But, if the countries with appreciating currencies are acting to reflate a sinking world economy, then they are correcting a deflationary global environment and not acting to create an unstable inflationary international environment.

While I see that leadership to stabilise the international financial environment must most of all come from countries with excessively appreciating currencies, there is also a role for the IMF. Where a single relatively small country is suffering from a rapid exodus of capital, there may be little sense of currency appreciation elsewhere. A collapse of the New Zealand currency, if not a part of a wider regional financial crisis, would have little impact on the rest of the world's currencies. In such an event, it would be appropriate for the IMF to create more of its own currency - the SDR (Special Drawing Right) - to deposit in NZ dollar denominated bank accounts. There should not be any conditions, because the IMF would only be acting to offset inappropriate capital flight.

To summarise, Plan C represents the actions that may be taken by countries with appreciating currencies (and by the IMF) to offset currency instability created by inappropriate capital flight. Plan C can work in conjunction with exchange controls in countries with depreciating currencies.

Plan C does not amount to an attempt to subvert the floating currency mechanism. In most cases, there are real reasons why the currencies of countries such as Thailand, Korea, Indonesia, Malaysia, New Zealand should have fallen in value. And there are real reasons why the US dollar and the Deutschmark should have risen in value. Such changes in value represent the important market signals that facilitate an orderly global trading environment. Plan C simply seeks to eliminate the overshooting; the excessive changes in currency values. Plan C represents both a correction and a stimulus to a teetering world economy.


© 1998

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