The Free Market 16, no. 1 (January 1998)
When the IMF declares a country an “economic miracle,” look out. A financial crisis cannot be far behind.
First it was Japan, the juggernaut that was said to be on the verge of supplanting the U.S. as an economic superpower. Then it was Mexico, the model of how former banana republics can be transformed into thriving market economies. Then it was the Czech Republic’s turn as a model of de-socialization. Then the Asian Tigers took their turn in a financial fall from grace.
The IMF is fast becoming handmaiden to the new international monetary regime. That fact explains its pathetic track record of predicting financial debacles and its penchant for bailing out failing economies. At last, the world has a lender-of-last-resort, a menacing Fed for the world, and its name is the IMF. The intellectual inspiration of the new regime is no less than John Maynard Keynes.
Keynes believed that one major defect of the free market was that it accumulated capital too slowly, in part because market interest rates are always too high. Society’s progress, Keynes thought, depends on a policy of reducing interest rates by central bank control of money and credit.
The Federal Reserve does this by creating new money and using it to purchase securities from banks. These open-market operations bid the price of bonds up and push interest rates down. This entices entrepreneurs to borrow for capital projects that would have been unprofitable at market rates of interest. This in turn brings about a boom in capital projects that Keynes thought could be extended indefinitely.
But as Ludwig von Mises showed, the interest-rate driven boom must end in bust since the newly created money cannot be confined to the credit markets. Instead, it will be spent again and again to buy consumer goods. Interest rates will eventually be pushed up again, and capital values and stock markets will collapse. The boom comes to an end.
Keynes recognized that the extent and duration of the artificial capital accumulation during the boom depends on the international monetary regime. The U.S., home to the world’s reserve currency, is able to extend its booms further and for longer periods than any other country by “exporting” its monetary inflation.
If the newly created money the Fed pumps into banks does not go into the hands of American consumers, it can be: (1) invested by American companies in foreign countries, (2) lent by American banks to foreign firms, or (3) spent by American consumers on imports and held by foreign central and commercial banks as reserves against their own currencies and in foreign commercial banks. If one or all of this happens, we don’t suffer a domestic recession.
This is precisely what has happened. Consider the paradoxical movement of the stock market and the GDP. The meteoric rise in the stock market, up about 28 percent per year for the six years of the boom, has resulted from the twin causes of low interest rates and high earnings.
The relatively anemic increases in GDP, about 2.5 percent per year during the same six years, coincides with an overseas boom in investment and production. This overseas boom does not count in the U.S.’s GDP. The U.S. economy dwarfs that of its foreign partners, so this transfer of production will lower our growth rate but greatly increase growth in smaller economies.
On the 1996 list of developing countries that received the largest amount of foreign, private investment, Indonesia, Malaysia, and Thailand rank third, fifth, and sixth. The regions of East and Southeast Asia received nearly half of the $243.8 billion in foreign, private investment.
China, now called the next economic miracle, has been far and away the largest recipient of foreign, private investment since 1992. It received $52 billion of these investment funds in 1996. To the extent that these capital projects are fueled by central-bank inflation, they are part of the “exported” boom. (If China escapes financial collapse, it will be due to its pace of privatization.)
To continue their domestic booms, adjunct countries must refrain from conducting an “independent” monetary policy. They must coordinate their own central-bank monetary inflation with the Fed’s. If instead their central banks pile domestic monetary inflation on top of the “imported” dollar inflation, domestic price inflation will rapidly follow, since they cannot “export” their own monetary inflation.
If they try to delay or deny the decline in their currencies’ purchasing powers by linking or pegging their currencies to the dollar, then instead of smooth, gradual decline they will face swift and massive devaluation. Devaluation, like its domestic counterpart price inflation, pushes interest rates up, causing capital values and stock markets to crash.
Evidence that this process was in full swing in Thailand was obvious in 1997. Its central bank had been inflating the baht at higher rates than Fed inflation of the dollar. Flush with funds, Thai banks extended loans to riskier and riskier projects ending up with speculative indebtedness in the expanding real estate bubble.
Thailand’s central bank responded to the advent of devaluation in typical fashion by abruptly halting its monetary inflation and, in an act of desperation, increasing its demand for the baht by using its dollar reserves to purchase the baht in international currency markets. Neither of these measures could overcome the force of the previous monetary inflation.
The upward spike of interest rates from the decline in the baht’s purchasing power and the reversal of central bank monetary inflation and credit expansion caused the real estate and stock markets in Thailand to crash. The Thai stock market fell 45 percent since the beginning of 1997. Suddenly the growing and profitable banks of yesterday were bankrupt as the value of their collateral collapsed and the number of bad loans soared.
Far from poor entrepreneurial judgment or lack of vigorous regulatory oversight, bankruptcy is an inevitable part of a central-bank-induced business cycle. It is the downward counterpart to the artificial expansion of bank loans and capital values of the boom. From the S&L debacle of the 1980s, to the continuing banking problems of Japan in the 1990s, to the current problems in Southeast Asia, the pattern is the same.
The Thai experience has been repeated with other Southeast Asian currencies. The Malaysian ringgit, Indonesian rupiah, Philippine peso, Singapore dollar, and Korean won all fell to speculative reassessment. Their currencies, stock markets, and banking systems collapsed. Malaysia’s market fell 48 percent, Indonesia’s fell 30 percent, Phillippines’s 45 percent, Singapore’s 33 percent, and South Korea’s 24 percent. (China is up 40 percent since the beginning of 1997.)
The nature of the international dollar-reserve system explains another aspect of the Asian currency debacle. What the U.S. government must avoid, if it wants to avert a similar financial debacle, is a repatriation of dollars held abroad.
According to the IMF, central-bank dollar reserves around the world are $423 billion, about 60 percent of their total reserves. In 1990, before the current dollar-led, worldwide boom, dollar reserves of central banks were only 50 percent of the total. From 1990 to 1996 the total foreign currency reserves held by all institutions increased by 80 percent to $1.45 trillion, of which 63 percent are dollars.
Any significant disgorging of these holdings would set in motion price inflation in America and the resulting upward spike of interest rates would result in a stock market crash, bankruptcy, and liquidation, quickly bringing our boom to an end.
Of these enormous and increasing foreign holdings, tens of billions of dollars are in the hands of the central banks of the Asian Tigers. Thailand spent about two billion dollars of its reserves to defend the baht before being dissuaded from this policy and convinced to let the baht float.
What convinced them was an IMF bailout of $17 billion. As with Mexico’s $50 billion bailout in 1995, the IMF arranged to compensate Thailand, and now the other Asian Tigers, so that defending the currency peg became unnecessary. For its part, Indonesia enjoyed a $23 billion gift from the IMF following its currency debacle.
More bailouts are planned. The IMF recently announced that its 181 members will increase its capital base by $285 billion, a 45 percent increase, to be the international lender-of-last-resort to bail out countries bankrupted by their own folly and greed. By increasing the incentive to inflate money and credit, this new role for the IMF will result in more frequent and severe international debacles.
Who’s next on the list of economies to fail? Brazil, Argentina, and Chile for starters. If an economic crisis is inevitable, the only way to overcome it is through a dramatic freeing of markets, such that bad investments are quickly washed out and prices are allowed to adjust.
Bailouts create perverse incentives and teach precisely the wrong lessons. The more of them the IMF performs, the more they will be made to appear necessary. The real lesson of the Asian currency crisis is this: only God can perform miracles. Central banks and the IMF merely produce inflation, business cycles, and financial crises.
Jeffrey Herbener teaches at Grove City College and is a senior fellow of the Mises Institute.
FURTHER READING: Austrian Theory of The Trade Cycle and Other Essays, edited with an introduction and postscript by Roger Garrison (Auburn, Ala.: Mises Institute, 1997); “Lessons of Asia’s Currency Crisis,” John Greenwood, Wall Street Journal (October 7, 1997).
