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Learning the Wrong Lessons from the Asian Financial Crisis: Martin Wolf Glosses Nouriel Roubini

Martin Wolf in the FT glosses Nouriel Roubini, but ends this episode with a cliff hanger: / Columnists / Martin Wolf - What Asians learnt from their financial crisis: The Asian financial crisis of 10 years ago taught two contrasting lessons: the one the majority of western economists thought the Asians should learn; and the one Asians did learn. The western economists concluded that emerging economies should adopt flexible exchange rates and modern, well-regulated and competitive financial markets. The Asians decided to choose competitive exchange rates, export-led growth and huge accumulations of foreign currency reserves. The question is whether the Asians need to change their choice. The answer, I believe, is “yes”.

When downward pressure on the Thai baht started 10 years ago, nobody expected what followed – its devaluation in early July. That seemingly small event generated a financial tsunami that engulfed most of east Asia and overwhelmed Indonesia, Malaysia, the Philippines, South Korea and Thailand. Exchange rates collapsed, financial systems went bankrupt, governments teetered on the edge of default and economies succumbed to deep recessions....

With the important, but geographically limited, exceptions of Argentina and Turkey in 2001, the crises of 1997-98 have so far been the last in the long series of financial crises that afflicted emerging economies in the 1980s and 1990s. Today, the desire of outside investors to put their money in these economies is overwhelming, as is shown in the strength of their financial markets, the low spreads on external borrowing and the size of the private capital inflow.... The IMF is now almost entirely out of business.

What explains this new stability? As Nouriel Roubini of New York University’s Stern School of Business argues, the Asians did not learn the lessons most western economists thought they should.... [T]he great mistake, Asian policymakers concluded, was not pegged, but overvalued, exchange rates. That error was what had brought the humiliating dictation by IMF officials operating under the thumb of the US Treasury. “Never again” became the watchword. Never again has been the result. Now the east Asian emerging economies are mostly creditor nations. Moreover, much of their accumulation of external assets is in official hands (see chart). By February of this year, the foreign currency reserves of east and south Asian countries had reached $3,280bn....

The scale of the reserve accumulation demonstrates the obvious: these countries have refused to adopt the freely floating exchange rates many outside economists recommended. They have, instead, chosen to keep their exchange rates down. This, in turn, has generated current account surpluses. Sustaining such surpluses requires a stable excess of savings over domestic investment. One instrument they have used has been sterilisation of the monetary consequences of reserve accumulations, to prevent the normal expansion of money and credit, overheating, inflation and so loss of external competitiveness.

If a substantial part of the world economy is generating huge current account surpluses, somebody else has to run offsetting deficits.... It is no accident then that the US has emerged as the world’s chief deficit country – its “borrower of last resort”. It alone is able to be a vast net borrower without risking the health of its financial system.... Mr Roubini argues that... [this] policy generates ultimately unsterilisable increases in foreign currency reserves. This causes excess monetary growth, domestic asset price bubbles, overheating, inflation and the loss in competitiveness that governments had tried to prevent by suppressing the rises in nominal exchange rates. It distorts domestic financial systems, by pushing interest rates below equilibrium levels. It generates a waste of resources in accumulation of low-yielding foreign currency assets exposed to the likelihood of huge capital losses. It makes Asian economies excessively dependent on demand from outside the region. It exacerbates US protectionism. Finally, it compels US monetary authorities to sustain easy monetary policy, in order to offset the leakage from domestic demand caused by the huge current account deficits.

The post-crisis policy system has proved more durable than many (including myself) expected. At its heart, however, is China. Though not affected directly by the crisis, it was one of the countries that learnt its lessons in the Asian way. Today’s result is a dynamic behemoth accumulating foreign currency reserves at a rate of $50bn a month in the first quarter of the year and expected by the IMF to generate a current account surplus of 10 per cent of gross domestic product this year. I do not believe these astonishing trends are desirable or sustainable. Why that is so and what to do about it I intend to discuss next week...