Download The International Monetary and Financial Policies of the Clinton

The International Monetary and Financial
Policies of the Clinton Administration
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J. Bradford DeLong ([email protected]) and Barry J. Eichengreen
([email protected])
University of California at Berkeley and NBER
May 2001
Abstract
I. Introduction
The Clinton Administration was nearly two years old before there was any reason for anyone to
think that international money and finance would be one of its central areas--if not the central
area--of concern. This focus on international money and finance would be new. Other issues had
been the core concerns of previous administrations. During the Bush I Administration, the
Prepared for the conference on the Economic Policies of the Clinton Administration,
Kennedy School of Government, 26-29 June. We thank, without implicating, Caroline
Atkinson, Jeffrey Frankel, David Lipton and Dan Tarullo.
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budget deficit, the trade deficit, the 1990-1991 recession, and any number of other strictly
economic issues--not to mention Operation Desert Storm, German reunification the collapse of
the Soviet Union, and the end of the Cold War--had far outweighed international financial issues.
Moreover, international financial issues were barely mentioned at all in the 1992 presidential
campaign, even though the last months of that campaign coincided with the collapse of western
Europe’s Exchange Rate Mechanism under a speculative attack that came as a complete surprise
to the then-current models of international financial crises.2
Figure 1: Exchange Rates During the ERM Crisis of 1992
Yet the Mexican financial crisis of 1994-1995 and the associated rescue package, the East Asian
crisis of 1997-1998, and attempts at reform of the “international financial architecture”
ultimately became major preoccupations of President Clinton and his senior advisors. In
retrospect, it is clear that this issue area ranks no less than second in the list of Clinton
Administration preoccupations and accomplishments--behind only the Reagan Administrationcreated budget deficit and the 1993 Clinton-Mitchell-Foley deficit reduction package to diminish
it.3
There were two sets of reasons that international money and finance became central concerns of
The so-called “first generation” models... Obstfeld... Crisis model footnote...
Clinton-Mitchell-Foley package ranks far ahead of Gramm-Rudman-Hollings or any
other Reagan-era initiatives in its success at reducing the budget deficit, but it ranks
behind the 1990 Bush I-Mitchell-Foley package and behind a healthy does of
macroeconomic good luck...
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the Clinton Administration. The first emerged from the White House. President Clinton and his
immediate staff wanted to focus on health care policy, welfare policy, public investment,
educating America, and the information superhighway. However, during the first two years of
the Clinton administration the White House staff lacked the administrative and political
competence to advance major domestic initiatives (other than the 1993 Clinton-Mitchell-Foley
deficit-reduction package) that could win the support of the central third of the Senate. And after
the loss of Democratic control over the Congress in 1994, all White House domestic initiatives
were obviously dead in the water.
The second set of reasons emerged not from Washington but from New York, London,
Monterrey, Buenos Aires, Seoul, and Jakarta. Just as Democratic would-be presidential
nominees began spending significant amounts of time in New Hampshire, portfolio capital flows
to emerging markets began to grow explosively, reflecting the effects of Brady Plan debt
restructurings and the progress of economic reform in Latin America.
Figure 2: The Growth of Portfolio Capital Flows, 1980-2000
The information and communications revolution that would be the subject of so much attention
and hubris later in the decade was also quietly underway, as international money managers and
foreign exchange speculators populated their desks with video display terminals and as the actual
location of international capital markets completed its shift into cyberspace, greatly reducing the
cost and thereby stimulating the volume of cross-border financial flows.4
The Bank for International Settlements, in its triannual survey of the level of foreign
exchange turnover, estimated that this had risen from $**** billion a day in 199* to $****
billion in 199*.
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Figure 3: Gross Volumes Traded on Foreign Exchange Markets
Moreover, the 1980s had already seen a large amount of domestic financial deregulation that had
made it very difficult to stop capital movements at the border. Deregulated domestic financial
markets opened new channels for response and evasion by financial institutions. Reflecting both
the fact and the ethos of financial liberalization, controls on capital flows in both advanced
industrial and developing economies were already well on the way to vanishing by 1992.5
Thus events as of the start of the 1990s had greatly amplified the desired volume of international
capital flows while removing many of the tools governments had used to control them in the
past. This raised the possibility that international financial flows might become “disruptive.”
They might feed the rest of the market economy "false" asset prices that did not correspond to
“fundamentals,” understood as the shadow values of capital in the appropriate social welfaremaximization problem. They might feed the rest of the market economy "true" asset prices
corresponding to fundamental values, but true asset price values that caused problems for
politicians. Thus as of the start of the Clinton Administration international monetary and
financial problems had acquired a potential for political salience and immediacy that they had
not possessed at least since the breakdown of Bretton Woods, and perhaps since the Great
Naturally, this shift first became evident in the advanced-industrial countries. There, the
turning point was the Single European Act of 1986, which required its signatories to
dismantle their remaining capital controls in order to forge a single financial market,
something they did in the run-up to 1992. In developing countries, the prevalence of
capital controls, multiple exchange rates and export surrender requirements reached a
local maximum in 1991 before declining sharply and monotonically thereafter. See
Eichengreen and Mussa et al. (1998), Figure 7.
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Depression.
Economists have long debated how--or if--governments should regulate international financial
flows and the international monetary system…
At the level of exchange rate policy, the argument between Milton Friedman and Robert
Mundell: Is the exchange rate a price? Then it must float freely, because prices need to be set by
markets--not governments. Is the exchange rate a promise--a commitment by the government to
the value of its currency? Then the exchange rate must be fixed, because the market economy
can function only if promises--contracts--are kept…
At the level of the regulation of international capital flows, there is…
The laissez-faire position that government regulation of international capital flows causes more
problems (corruption, evasion, et cetera) than it solves…
The restriction position that large-scale portfolio capital flows are too dangerous to be allowed…
Everything in between…
In this paper we analyze how it was that in the 1990s this potential for political salience became
actual, what efforts were undertaken by the Clinton Administration to grapple with the actual
international financial problems it faced, and what the results of these policies were.
We conclude that...
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Before proceeding, it behooves us to comment on methodology. The studies of policy making
undertaken by political scientists and journalists typically proceed at one or more of four levels:
ideas, interests, institutions, and personalities. The question is whether policy choices are shaped
mainly by intellectual outlook and ideological predisposition, by lobbying on the part of
powerful special interests, by institutional constraints and bureaucratic inertia, or by the triumphs
in bureaucratic warfare of senior officials. Our choice of level is determined by the old principle
that where you stand depends on where you sit. We both worked inside the Beltway for part of
this period. We do not deny the importance of personalities, but we do emphasize that senior
officials won bureaucratic battles only where they had strong and powerful institutional bases.
We do not deny the importance of ideology and of material interests, but once again their roles
were very significantly shaped and filtered by the policy-making institutions as they existed on
the ground during the 1990s.
2. The Strong Dollar Policy
When President-elect Clinton assembled a star-studded cast of experts in Little Rock during the
interregnum between the election and the inauguration, he did not question them about the
problem of managing capital flows and averting threats to international financial stability. His
concerns, indicative of the times, were rather with the trade and budget deficits, and his
predispositions, unsurprisingly for a Democrat, were activist. One prominent academic known
to this audience won no points when he responded to a question about what should be done about
the trade deficit by saying, in essence, “nothing.” Clinton’s eventual choice to head the Council
of Economic Advisors, Professor Laura Tyson of the University of California, Berkeley, was an
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advocate of the aggressive use of trade policy to pry open foreign markets with the goal of
bringing down the trade deficit.
There were impediments, of course, to the aggressive use of trade policy. The United States had
already concluded a major free trade agreement with Canada. It had its GATT commitments.
The promise of closer trade relations were an obvious way of supporting economic liberalization
and democratization in Latin America and the former Soviet bloc. Candidate Clinton had
already opted to support NAFTA and the Uruguay Round during the 1992 campaign out of a
conviction that the economy had to move forward and not backwards (where forward in part
meant globalization) and in order to define himself as a New Democrat and distinguish his views
from those of the then-prevailing Congressional Democratic position.
Moreover, the traditional constituency for protection, the import-competing manufacturing
sectors of the Rust Belt, figured less importantly in the U.S. economy and therefore in the
political debate than they had a decade before, while U.S. exporters of goods and services,
financial services in particular, who gained additional voice and were unlikely to look
sympathetically on the use of trade-unfriendly measures. While the Administration made heavy
use of anti-dumping measures, both those to which it was entitled under the GATT and unilateral
measures such as Super 301 (Section 301 of the 1988 Omnibus Trade and Competitiveness Act)
to which it was not, its commitment to free trade was never in doubt.6
The incidence of antidumpting actions fluctuated with the level of the dollar, falling
between 1992 and 1995, along with the currency, and rising thereafter (Knetter and
Prusa 2000).
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The one instrument obviously available for addressing the trade deficit and the concerns of
import-competing producers was the level of the dollar. There were several reasons for thinking
that the new administration might try to push or at least talk down the dollar. This had been the
observed behavior, or at least the imputed temptation, of previous incoming Democratic
Presidents: Franklin D. Roosevelt had depreciated the dollar to deal with the macroeconomic
problems he inherited, and it was widely thought that John F. Kennedy would do the same when
he took office in 1961. Treasury secretaries hailing from Texas (James Baker and John
Connolly), closer to the country’s commodity-producing heartland than its financial center, had a
record of favoring a weak dollar; thus, Clinton’s selection of Lloyd Bentson as his treasury
secretary was taken in some circles as a signal of the Administration’s prospective approach to
the exchange rate.
Figure 4: The Real Value of the Dollar, 1970-2000
Nor can it be argued that anything that could remotely be called a “strong-dollar policy” was in
place in the early Clinton years. The dollar declined from Y125 when Clinton took office to Y80
two years later, an exceptionally sharp swing in such a short period even by the volatile
standards of the 1970s and 1980s.7 (See Figure 4.) The “economic populists” in the White
House (George Stephanopoulos, for example) saw a weaker dollar as useful for enhancing U.S.
international competitiveness. Nor did Bentson obviously oppose a weaker dollar, which he saw
While the dollar strengthened against the Mexican peso and the Canadian dollar,
moderating the decline in the (trade-weighted) effective exchange rate, it was the yendollar rate that attracted the attention of financial-market participants and the concern of
policy makers.
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as helpful for solving the trade-deficit problem.8 U.S. Trade Representative Mickey Kantor saw
a weaker dollar as giving him leverage in trade negotiations, since he could argue that it was
Japan’s “unfair advantage” due to barriers to imports of automobiles and parts that was
responsible for the weak currency that found disfavor among foreign governments.
That said, there were several causes for concern over the weakness the dollar displayed in 19934. The currency’s slide threatened to fan inflation. In the short run, it hurt rather than helping
with the trade deficit due to the J-Curve effect (that is, the tendency for import prices to rise
before import volumes began to fall). (See Figure 5.) Fears about inflation and about the
sustainability of the external deficit combined to raise the specter of higher interest rates, which
unsettled the financial markets.9 The dollar’s continued decline created financial volatility and
increased the cost of credit by inflicting losses on financial firms (hedge funds, among others)
that had gone long on the dollar and shorted the yen and deutsche mark in late 1993 and early
1994.10 All this combined to create a desire for some kind of action to strengthen the currency.
Figure 5: The U.S. J-Curve
Bentson’s reputation, perhaps undeserved, for favoring a weaker dollar resulted from an
off-hand response to a reporter’s question in which he observed that a weaker dollar
would boost U.S. exports.
See for example “Weaker Greenback Campaign Heats Up,” Capital Markets Report,
Dow Jones News Service, 10 December 1996.
See International Monetary Fund (1994).
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At a deeper level, the strong dollar policy was part and parcel with the administration’s overall
fiscal and monetary strategy. Clinton had campaigned for a middle-class tax cut and additional
public spending on infrastructure and skill formation, but his administration inherited an
exploding budget deficit that left little room for such initiatives. The only hope was that deficit
reduction would bring down interest rates and create an environment conducive to faster
economic growth and therefore to the shared prosperity that the candidate had promised the
middle and working classes. As a result of a series of internal struggles (colorfully recounted by
Woodward 1994 and Reich 1997), the decision was made to eschew substantial new spending
programs and middle-class tax cuts and to focus instead on fiscal consolidation in order to create
a financial environment conducive to investment and growth.11
Figure 6: Implicit Expectations of Future Short-Term Interest Rates Contained in the
October 1992 Yield Curve
How was the level of the dollar related to this choice? Reducing the interest rates on which
investment depended were the key to stimulating faster growth.12 The Federal Reserve Open
Market Committee, it was hoped, would see fiscal consolidation as implying a reduction in
inflationary pressure and respond by cutting short-term interest rates. They were most likely to
do so if the financial markets perceived things in the same way and bond prices responded
Within two years of the President’s inauguration, the Council of Economic Advisors was
highlighting the close connection between investment and productivity growth, thus
suggesting that the lower interest rates needed to boost investment were the key to
faster growth. Council of Economic Advisors (1995), pp.27-28.
The also had the ancillary advantage of addressing the problem of chronic budget
deficits by reducing debt-servicing costs.
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positively to such news, thus lowering long-term interest rates as well. From this point of view,
a belief that the U.S. exchange rate was destined to weaken was a danger.
In a world of international mobile capital, U.S. long-term interest rates would inevitably exceed
foreign interest rates to the extent that the dollar was expected to fall. In economists' standard
model of exchange rate determination, the level of the current exchange rate  is equal to foreign
exchange speculators' estimate of the long-term fundamental value of the exchange rate plus or
minus the capitalized interest rate differential between home and abroad. The higher are foreign
exchange speculators' estimates of the long-run fundamental value of the dollar, the lower is the
domestic interest rate consistent with any particular current market equilibrium value of the
exchange rate. Want lower domestic interest rates? Then either accept that they come
accompanied by a lower value for the dollar, or undertake countervailing steps to rise foreign
exchange speculators' views of long-run fundamental values.
Moreover, since expectations of higher import prices were a factor to which the Federal Reserve
looked when forecasting inflation, a falling dollar fanned fears among financial-market
participants of rising Federal Reserve discount rates. For these and other reasons, the belief that
the Administration might push the dollar down, perhaps in response to pressures emanating from
domestic auto and steel producers, had to be vanquished in order to reap the full benefits of
deficit reduction and implement the investment-led growth strategy. Undersecretary Summers
saw the linkage between exchange rate policy and interest rate policy from his arrival at Treasury
and was the main opponent in these early days of arguments in favor of pushing down the
dollar.13
Summers publicly stated as early as August 1993 that a strong yen (politically, an easier
name to attach to the phenomenon than a weak dollar) was not in the interest of the
U.S. economy. All this makes it ironic that Summers’ commitment to the policy was
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The strong-dollar policy was inaugurated by the transition from Bentsen to Rubin at Treasury at
the beginning of 1995.14 Rubin had been central to the campaign for lower interest rates as a
way of energizing U.S. economic growth, and Summers’ analytical arguments against pushing
down the dollar coincided with Rubin’s instincts honed by years of experience with financial
markets. In his confirmation hearings before the Senate Finance committee, Rubin stated that a
strong dollar was in the best interest of the U.S. economy and warned that the exchange rate
should not be used as an instrument of U.S. trade policy.
The new approach acquired a name as the result of three events in the spring of 1995. First,
there was the prime-time news conference on April 19th during which Clinton stated that the U.S.
“wants a strong dollar” and that it “has an interest over the long run in a strong currency.”
Second, there was the extraordinary statement on April 25th by G-7 finance ministers, meeting
under Rubin’s chairmanship, who overcame their normal reticence about addressing such
delicate matters and declared that a reversal of the decline of the dollar against the yen was now
desirable. And finally there was joint intervention in the foreign exchange market by the U.S.
and Japan, with the periodic support of Germany and other G-7 countries, to support the
widely questioned when he succeeded Rubin as Treasury Secretary in 1999.
Bentson had asserted in a July 1994 speech in New York that the Administration
favored ‘a stronger dollar,” but any impact on the markets was offset by the President’s
statement at the G-7 summit in Naples a few days later that “it is important not to
overreact” to the currency’s weakness. Combined with Bentson’s jawboning of the Fed
not to raise interest rates, the impression, according to financial commentary, was that
the Administration still favored a weaker dollar. See Wall Street Journal Europe (July
12, 1994), p.10; Economist (July 16, 1994), p.74.
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currency, starting in March and April of 1995 (accompanied by comments by Rubin that the
intervention reflects “a shared commitment to a stronger dollar” and a common view that a
stronger dollar “is in the most general interest of the economies of the world.”15
By mid-summer the currency had reversed course.16 The Federal Reserve began lowering
interest rates in a trend that similarly dates from the summer of 1995.17 The statement that the
U.S. preferred a strong dollar became the regular mantra of Administration officials, and
discipline was imposed to ensure that statements regarding the exchange rate would be made by
the Treasury alone. Still, it took a surprising amount of time for the existence of a new policy to
be recognized. Figure 3, which shows the number of Nexus-Lexus hits on “strong dollar” and
“strong-dollar policy”), suggests that while this realization first dawned in 1996 (leading the
National Association of Manufacturers and U.S. auto producers to complain that currency
appreciation was hurting their exports), it really only took hold in 1998.
3. The Mexican Rescue
Wall Street Journal (April 6, 1995), p.C11.
It had moved up to nearly Y120 (a 42 month high) by the time of the November 1996
election.
The strong dollar and the anti-inflation effects of its appreciation were only one factor
behind the adjustment of monetary policy; more important surely were signs of distress
in financial markets and worries about an economic downturn.
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The North American Free Trade Agreement, as negotiated and signed in December 1992 by the
Salinas and the Bush administrations and as amended and implemented by the Salinas and
Clinton administrations in 1993, offered Mexico two major benefits. It did not offer Mexico any
significant increase in access to the U.S. market: the U.S. market was already almost completely
open to imports from Mexico. Rather it offered, first, a solemn promise to Mexican businesses
and investors that their enterprises would not be bankrupted by a sudden wave of U.S.
protectionism. A second and more important benefit of NAFTA for Mexico lay in the obligations
to continue market-friendly reforms that the treaty placed on future Mexican governments. The
NAFTA tied Mexico's program of economic reforms to a formal international agreement,
diminishing the chance that Mexico would abandon reform. Most of the benefits from promarket reform programs in developing countries hinge on their actual and perceived
permanence. The worst of all worlds is to enact policies that hurt politically-powerful interests,
but then to fail to reap the benefits because investors and producers fear that the policies will not
be sustained.
Figure 7: Mexican Trade Barriers Over Time
1993 saw a whole host of different arguments made for NAFTA. Some of the arguments--the
U.S. duty of leadership in foreign policy; the U.S. national interest in a faster-growing and moredemocratic Mexico; the global interest in economic policies to help someday make us one world,
rather than two or three--seem sound. Some of the arguments--economic alliance with the
emerging Mexican superstate, defeating the Japanese on the battlefield of the Mexican market,
using the Mexican labor force in a mercantilist struggle against Japan--simply seem analytically
wrong.
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BY the spring of 1994, Alejandro Werner and Rudiger Dornbusch and others (Calvo, Leiderman,
and Reinhart; the Congressional Budget Office report on NAFTA; and a third) had issued a
warning about the state of the Mexican economy. They argued that the Mexican government was
doing most things right: the government budget had shifted from substantial deficit to surplus,
thus no longer draining Mexicans' savings pool; businesses were being privatized; and tariffs
were being lowered. Yet they warned that growth was slow. Dornbusch and Werner argued that
the reason growth was slow was that the nearly-fixed peso-dollar exchange rate coupled with
differential higher inflation in Mexico had left Mexico with an overvalued currency. While
foreign investors still viewed Mexico as a good place to put their money, Mexicans realized that
at current exchange rates additional real investments in Mexico were likely to be unprofitable.
Mexicans were taking the additional money foreign investers offered--a current account that had
shifted from balance to a deficit of 5 percent of GDP over half a decade--but they were using it
to finance increased consumption rather than increased investment.
Figure 8: Mexican Growth on the Eve of NAFTA
The obvious solution appeared to be to let the peso's value fall by twenty percent, and let the
peso then drift downward by as much as Mexican inflation exceeded U.S. inflation in order to
keep Mexico from losing competitiveness again. The major argument against this was the belief
that the slowly-crawling band within which the peso was allowed to fluctuate was the principal
reason for the success of the Mexican government's anti-inflation program. Without this nominal
anchor…
In December 1994, after a year of political assassinations, a not-very-clean presidential election,
and an armed guerrilla movement that appeared in Chiapas in January (and thereafter relied not
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on its weapons but on the justice of its demands and grievances), Mexico ran to the edge of its
foreign exchange reserves and announced the devaluation of the peso. But the peso fell by far
more than the twenty percent. It fell by fifty percent. Economists and observers had been
expecting to see a small devaluation that would diminish many of Mexico's economic problems.
But what took place was a large devaluation that turned into an economic crisis.
From nearly $30 billion before the assassination of Presidential candidate Colosio in March,
foreign exchange reserves had fallen to perhaps $5 billion when the decision to abandon the
pegged exchange rate against the U.S. dollar was made in December. At each stage of 1994, the
Mexican government--preoccupied with the not-very-clean election campaign--bet that the
drawdown of reserves was a temporary shock, rather than a permanent change in foreign
investors' demands for Mexican assets. Up until late summer it was hard to say that the Mexican
government was wrong: even in October of 1994 foreign exchange reserves were some $18
billion, more-or-less unchanged from April 1994. The flow of foreign portfolio investment into
Mexico had stopped in the wake of political assassinations and the Chiapas rebellion, but the
flow of portfolio investment had also stopped when the U.S. Congress looked ready to reject
NAFTA, only to resume after the NAFTA implementation votes. And Mexico's economic
fundamentals--a balanced federal budget, a successful privatization campaign, financial
liberalization--were strong enough in the spring of 1994 to elicit "a strong and unqualified
endorsement of Mexico's economic management" by the IMF.
Figure 9: The Value of the Peso
Part of the Mexican government's strategy for retaining confidence in its stable exchange rate
throughout 1994 was to replace conventional short-term borrowing with the famous
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"Tesebonos", a short-term security whose principal was indexed to the dollar, as a means of
retaining the funds of investors who feared devaluation. In retrospect, this was a double or
nothing bet. This policy was effective in the short term but risky: it did retain some $23 billion of
foreign financing, but it meant that if a large devaluation did come it would be an order of
magnitude more dangerous and destructive.
A large devaluation would be more dangerous and destructive because…
Open-economy Bernanke-Gertler, in Paul Krugman's phrase…
Financial fragility…
The side effects of the principal-agent problem that confronts any saver wishing to commit his or
her wealth to some entrepreneur's business. The entrepreneur knows vastly more about how the
business is doing. The owner of the capital has very limited ability to monitor and assess what is
going on at the level of the operating business. Thus the web of credit and intermediation is
fragile and extremely vulnerable to deflation because of its impact on the amount the
entrepreneur has at risk, and thus on the magnitude of this principal-agent problem.
Because of this principal-agent problem between savers and entrepreneurs, it is optimal for
owners of capital to structure their relationships with entrepreneurs so that they are forced to
monitor the progress of the business as little as possible. And a good way to do that is through a
debt contract: the owner of the capital receives a fixed sum in all states of the world in which the
entrepreneur can pay that fixed (but negotiated ex ante) sum back to his creditor, and in those
states of the world in which the entrepreneur cannot pay his or her rights are extinguished in
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bankruptcy, and the original owner of the capital gains control over and property rights to all of
the assets of the firm.
These debt contracts interpret a failure to pay as a signal that real entrepreneurs have had bad
luck or have failed to properly manage their enterprises, hence that their enterprises need to be
liquidated. This form of financial fragility makes a financial crisis a dangerous exercise for an
economy.
If a country's government, banks, or operating companies have large debts denominated in
foreign currency, then a depreciation of the currency may set in motion the same debt-deflation
chain of bankruptcies and financial collapse modelled by Bernanke-Gertler…
A standard reaction when a country suddenly finds that foreign demand for its current-account
goods and services exports has fallen, or that foreign demand for its capital-account exports--for
investments located on its territory--has fallen, is to allow the exchange rate to depreciate. When
demand for a private business's products falls, one natural response is for the business to cut its
prices. When demand for a country's products--and that is what exports plus capital inflow are,
demand for a country's products--falls, the natural response is for a country to cut its prices. And
the easiest, simplest, and most straightforward way to accomplish this is through an exchange
rate depreciation. But not if the country's banks and operating corporations have borrowed
abroad in hard currencies. Then a depreciation writes up the home-currency value of their debts,
erodes their entrepreneurial net worth, and sets in motion the debt-deflation process.
By the end of 1994 it had become public knowledge that the inflow of foreign portfolio capital to
Mexico had not resumed. In a pattern that would be repeated in the Asian crisis two years later,
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each investor in Mexico feared that other investors would pull their money out of Mexico no
matter what the cost, and that the last investor to withdraw money would lose the greatest
amount of invested principal--either through near-hyperinflation, as the Mexican government
frantically printed pesos to cover its peso-denominated debts; through capital controls, which
would trap money in Mexico for an indefinite time (and eat up a substantial fraction of its value);
or through formal default: a repeat of 1982's dealings with commercial banks.
With $5 billion in reserves, with $23 billion in Tesebono liabilities that would be converted into
dollars and pulled from Mexico as it matured, and with no one willing to lend in hard currency to
Mexico for fear of becoming losers in the financial crisis, Mexico had no good choices. Either
the Mexican government would push interest rates higher than sky-high to keep capital inside the
country--in which case the extraordinary cost of money would strangle investment and
employment--or the Mexican government would find itself unable to borrow, start printing
money at a rapid rate to meet its applications and see prices spiral upward in what might become
hyperinflation.
All this was not preordained, for as an economy Mexico was not insolvent. It was merely
illiquid. If investors had been willing to roll over Mexico's short-term debts, contractionary
policies and a moderate devaluation to reduce imports and encourage exports to pay the Mexican
government's foreign liabilities as they came due. Such a moderate devaluation coupled with
contractionary policies might cause a recession, but a recession that would be much shorter and
much shallower than what faced Mexico in the absence of funds to roll over its short-term debts.
Thus the support package: the United States, the International Monetary Fund, and stray other
amounts totalling perhaps $40 billion in dollar-denominated assets that Mexico could draw upon.
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How do we know that Mexico was not insolvent but illiquid, and that once its debts were
rescheduled, the country would be able to make the payments on its foreign debt? We know in
the first place because the support package worked: Mexico registered a $7.4 billion trade
surplus in 1995. Real exports were more than 30 percent higher in 1995 than in 1994, while
imports fell by more than 8 percent. Generating such an export surplus in such a short time was a
consequence of the involuntarily-large devaluation and the squeeze the crisis put on the Mexican
economy. Real GDP fell by 9.6% between the third quarter of 1994 and the third quarter of 1995.
U.S. pulls its money out in 1996 for domestic political reasons…
The initial willingness of the executive and legislative branches of the U.S. government to work
together to minimize the impact of the peso crisis was heartening. After all, "economic
engagement" with Mexico was the policy of the Democratic executive and of the Republican
legislative majority. But support quickly eroded. Speaker Gingrich's lieutenant, Majority Leader
Armey, began to demand that the Administration gather over 100 House Democratic votes for
the package. Perennial presidential candidate Patrick Buchanan called the support package a gift
to Wall Street: "not free-market economics [but] Goldman-Sachsanomics." Ex-consumer
advocate Ralph Nader urged the Congress to vote down the support package and to demand that
Mexico raise wages. Columnists in the Wall Street Journal demanded that support be provided
only if Mexico first returned the peso to its pre-December parity. Isolationist Republicans and
anti-NAFTA Democrats claimed that NAFTA had caused the crisis, and vowed to fight the
package. It was not that anyone disagreed with the argument that Mexico was suffering from a
liquidity crisis in which substantial support from other countries could do a lot of good at
minimal risk--the debate was never joined on those terms. What seemed to excite rage was that
the U.S. government wanted to do something nice for Mexico. And, even worse, to do something
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nice for investors in Mexico.
Perhaps the strangest development came in a letter Republican Congressional leaders sent to
President Clinton. They urged the President to use the Treasury's Exchange Stabilization Fund
[ESF] to make loans to Mexico. The legislation governing use of the ESF assumed that it would
be used for short-term exchange market interventions to stabilize the dollar's value in terms of a
basket of other major international reserve currencies; it had never entered anyone's mind that the
Executive Branch had the power to use the ESF to stabilize the peso against the dollar.
The Congressional leadership thus abandoned a measureable amount of Congress's institutional
power with not a single whimper. The legislative branch is usually jealous of its authority, and
eager to defend its powers against other branches. But not here, where the legislative leadership
abdicated control over some $20 billion of U.S. assets to the Executive Branch…
Mexico's rapid recovery since 1996…
The Mexican distribution of income…
4. Responding to the Asian Crisis
In 1996 international investors poured perhaps $100 billion into East Asia. East Asian economies
were the darlings of the world capital market: it seemed as if everyone who wanted to lay claim
to any financial sophistication was diversifying into these fast-growing economies. In 1998 some
$40 billion of capital on net flowed out of East Asia.
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Figure 10: East Asian Growth
Figure 11: Capital Flows to East Asia
Where did this sudden shift come from? Surely some mighty and glaring errors of economic
policy must have been committed in order to cause this crisis in East Asia: what were they?
"Crony capitalism" and "unsustainable investment" and "weak financial systems" and
"overlending." But overlending and non-performing loans were little worse in the East Asia of
1997 that suffered such a crisis than in the East Asia of 1996 that did not. "Crony capitalism" and
"unsustainable investment" and "weak financial systems" were no worse in 1997 than in 1990 or
1985 or 1980 or 1975 when there was no crisis.
Long-term structural problems increased vulnerability, but did not cause the crisis…
Hard to avoid the conclusion that financial markets did not do a good job: either they were
excessively exuberant about East Asia before 1997, or they were excessively pessimistic in
1997-1998--probably both.
And in every year before 1997 those who worried about "overlending" in East Asia were wrong:
those who invested in East Asia received enormous profits, as East Asia proved to be the most
rapidly-growing and fastest-industrializing region that the world economy had ever seen. We
can't find any cause of the shift in investment patterns that is proportional to the effect. The shift
in Wall Street's desires to invest in East Asia appears to have been impelled much more by the
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trend-chasing and herding instincts of Wall Streeters--a community of people who talk to each
other too much, and whose opinions often reflect not judgments about the world but simply
guesses about what average opinion expects average opinion to be--than by any transformation
in the fundamentals of East Asian economic development.
And here we have reached the limits of economics. Economists are good at analyzing how asset
markets work if they are populated by far-sighted investors with accurate models of the world
and long horizons. Economists are even good at pointing out that such asset markets can be
subject to multiple equilibria--situations in which it is rational to be optimistic and rational
investors are optimistic if they think that everyone else is optimistic, and in which it is rational to
be pessimistic and rational investors are pessimistic if they think that everyone else is
pessimistic.
But what determines which of these "multiple equilibria" actually happens in the real world?
What determines the switch of an economy from one such configuration to another? The
transactions that economists analyze are economic transactions: purchases and sales of goods and
assets made with an eye toward maximizing wealth or expected utility. But the transactions that
determine which equilibrium will match investor expectations are social and psychological
transactions: flows of gossip through telephone wires, the spread of rumors, people taking notice
of other people's worried frowns or confident expressions--all of this taking place around the
globe at the speed of light, as news and information and gossip and rumor propagate through the
social network of investors.
This sudden shift meant that $140 billion a year that had financed investment in East Asia was
no longer there. That $140 billion had financed the employment of perhaps 25 million people in
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the region who were working in investment industries. They dug sewer lines, built roads, erected
buildings, and installed machines as both domestic and foreign investors bet that there was lots
of money to be made in East Asia's industrial revolution. As the capital inflow vanished, the jobs
of those 25 million people vanished too. They had--suddenly--to try to find new jobs.
Wall Street's sudden shift in attitude left demand for dollars by East Asians to finance imports
some $140 billion a year higher than the supply of dollars to them earned from exports.
Whenever demand is greater than supply prices rise: a rise in the price of dollars is a fall in the
value of other currencies, which fell until the supply and the demand for foreign exchange are
brought back into balance. In the long run economists hope that the fall in the value of a currency
will bring the supply of and demand for foreign exchange back into balance. Falling exchange
rates make domestically-produced goods more attractive to European and American purchasers,
and tend to raise export. Falling exchange rates make foreign goods expensive, and so imports
fall.
But in the short run a falling exchange rate meant (i) that foreigners bought more East Asian
goods, yes, but also (ii) that they paid fewer dollars for each good they buy. J curve… Need
capital flows of some kind (private or public) as a bridge loan while you traverse the J-curve…
Moreover, falling exchange rates bankrupted firms and financial institutions with home-currency
assets and dollar liabilities. Once again, open-economy Bernanke-Gertler…
East Asian governments by themselves could stop their exchange rates from falling by raising
interest rates to sky-high levels. But high interest rates made it unprofitable to invest or build.
Thus East Asian governments were damned if they let exchange rates fall, and damned if they
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tried to keep exchange rates higher by raising interest rates…
Thus once again the need for financial support. Lending dollars to East Asian countries kept their
exchange rates from falling as far and their interest rates from rising as high as if the countries
were left on their own. With less of a decline in exchange rates, fewer firms and financial
institutions with dollar liabilities went bankrupt. With less of a rise in interest rates, fewer
investment and construction projects were cancelled. The East Asian depression was smaller
than it would be otherwise.
This time, however, the U.S. was in the background. The IMF took the lead. Did the IMF get its
money's worth of lender-of-last-resort services from the massive resources it committed to the
East Asian crisis? Radelet and Sachs say "no"…
The IMF is not a sovereign. The IMF cannot print money. The IMF is an institution with limited
resources. There will be future financial crises, and so the IMF's first priority is to make sure that
the countries it lends to pay it back, and in order to do that they must have export surpluses in a
couple of years. The IMF's survival as an institution to help handle future financial crises
depends on its getting its money back. Thus the policies that the IMF requires in return for its
assistance are different from the policies that would have minimized East Asia's depression
because the IMF is fearing the consequences for future financial crises should it not survive as an
institution…
It might be a better world if the IMF did not believe that its survival as an institution was at risk
every time it intervened in a major financial crisis, and if the IMF could adjust policies to
minimize the depressions that follow financial crises. But the IMF we have needs to get its
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money back…
And the IMF we have worries about moral hazard…
January 10, 1998. Economist leader on East Asia. Suggests that the IMF is doing more harm than
good. The introductory paragraphs pose the question "should these bail-outs be happening at
all?" Two paragraphs then minimize systemic risks from letting the crisis burn itself out . Two
more paragraphs set up the argument for lenders-of-last-resort so that the three key paragraphs of
the article can knock it down: one explaining how bail-outs can create "moral hazard", one
arguing that this series of bail-outs amplifies mistakes made by Asia's banking regulators, and
one casting doubt on IMF competence and power. Article is summarized by readers like Slate's
Seth Stevenson as "...disapprov[ing] of the International Monetary Fund's bailout. The recession
it is supposed to prevent might never have happened, and rescuing financiers who make mistakes
encourages them to make the same errors again."
"Moral hazard play"….
Speed of recovery… Korea, Thailand, Malaysia. Non-recovery: Indonesia…
Beliefs about the East Asian crisis two years ago...
...fundamental structural reform needed
...the end of the Asian miracle
...future growth will be slower--much slower
...future growth will have to be different, relying much more on TFP growth and much less on
factor accumulation.
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How do these beliefs look today? Not too good.
Caveat: the Japanese economy continues in severe recession.
The point is that the proper response to a crisis depends on what kind of crisis it is. And lendersof-last-resort in financial panic and disorderly workout cases should recognize that in a sense
fundamentals were sound in East Asia--and that in such cases there should be a kinder, gentler
IMF. But on the other hand you can never be certain in real time of the mix of crisis types: all
crises are mixtures, with some "moral hazard" and some "policy induced" component as well as
"financial panic" and "disorderly workout" components. So you should never make policy as if
the crisis is entirely made up of one and only one pure type.
Moreover, as far lenders that put their existence at risk by the scale of intervention are
concerned, they have to be prudent, to act as if the crisis has a substantial policy-induced and
moral-hazard component. In this case the IMF very badly needs to get its money back quickly, in
time for the next crisis, due in 2001.
5. Strengthening the International Financial Architecture
The severity of the Asian crisis ignited a debate which still simmers about new and improved
mechanisms for the prevention and abatement of financial crises. The Clinton Treasury was
quick off the mark with speeches by Secretary Rubin at Georgetown and Brookings in February
1998 on the need to “strengthen...the architecture of the international financial system.”18
Actually, Rubin’s speech was not the Administration’s first foray into this area. Although the
See Rubin (1998a).
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Mexican rescue had not provoked an equally contentious debate, it had created concerns, both
inside and outside the Administration, about moral hazard. And it had raised red flags about
inadequate transparency and… [to come from Barry]
6. Conclusion
A look back: Bretton Woods and the regulation of international capital flows:
Keynes envisioned a much better-funded institution than White did, capable of taking action on a
much larger scale. (I should point out that the IMF today has only a fraction of the resources that
White thought necessary, and only a tiny fraction of resources that Keynes thought desirable.)
Keynes saw a balance of payments imbalance as a problem for both surplus and deficit countries,
both of which needed to be encouraged to change their policies. White saw a balance of
payments deficit as the problem of the country running the deficit which needed to change its
policies to correct the problem. (White was mistaken: Keynes was more farsighted.)
Skidelsky quotes (p. 253) a critic of both plans who had a much clearer view of what was at
stake. This critic at the time saw both plans as near-identical twins: "'both plans set up a supernational Brains Trust which is to think for the world and plan for the world, and to tell the
governments of the world what to do.' They were both British plans... both reflected trends in
Keynesian thinking and British monetary policy..." Keynes agreed that the differences were less
important than the similarities. He focused not on what was left undone but on what was
accomplished, and what was accomplished was "... a revolutionary change for the better
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compared with the position in the interwar period..." (p. 328).
Bretton Woods built on a fear of destabilizing speculation, and a belief that countries could
control capital flows without disastrous consequences (either for individual liberty, for the
honesty of government, or for economic efficiency).
We today fear restriction of international capital flows because of what it does to the rule of law
in countries that control capital flows--corruption.
We today fear restriction of capital flows because of the difficulty of the task--bureaucracy.
We today fear restriction of capital flows because of increased international divergence--the
benefits of capital flows for technology transfer from rich to poor…
Remember that the right thinks that because of the IMF East Asian economies did not suffer
enough, while the left thinks that, because of the IMF, East Asian and Wall Street power elites
did not suffer enough. All the political criticisms from right and left are that somehow the IMF is
giving the hard-earned wealth of first-world taxpayers away to the unworthy, and should stop.
On the political level, many calls for making the IMF more "accountable" are thus implicitly
calls for it to loan less--and impose more conditionality--on borrower economies.
We should neither encourage governments to choke off international flows of saving and
investment, nor look with schadenfreude on and discourse on the long-run salutory effects of the
great depressions caused by international financial panics. Instead, we should try to have our
cake and eat it too: to reap the benefits of international capital mobility, and to minimize the
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human costs of recurrent crises through appropriate and well-funded international central
banking institutions and practices.
We should try to have our cake because the benefits of international capital mobility truly are
mammoth. Between 1994 and 1996 some $200 billion of international capital flowed into
Malaysia, the Philippines, South Korea, and Thailand. In all of these countries the private return
on investment is high--higher than in the industrial core. In all of these countries the social return
on investment is higher still: if the economic history of the past two centuries teaches us
anything, it teaches us that investments in modern machine technologies are a very good if not
the best way to upgrade the skills of the labor force and gain the organizational expertise
necessary for high total factor productivity.
Just as the flow of finance from the British core to the periphery in the late nineteenth century
played an important role in producing the Australian and North American economies that have
had the world's highest standard of living in the twentieth century, so the flow of finance from
today's industrial core to the NIC periphery has every prospect of cutting a generation or so off
of the time needed for East Asian workers and consumers to achieve industrial core levels of
productivity and economic welfare.
We should try to eat our cake too because the costs of unmanaged international financial crises
are horrific. Because of the Latin American debt crisis of 1982 the decade of the 1980s was lost
to Latin American development--leaving the typical Latin American country between five and
ten percent poorer at the beginning of the 1990s than it would have been in a counterfactual
world in which borrowing from abroad had not financed oil imports and elite consumption in the
late 1970s. The financial crisis of 1873 saw the share of the U.S. non-agricultural labor force
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employed in building railroads fall from perhaps eight to perhaps two percent. And international
financial crises turned the global recession of 1929-1931 into the Great Depression, generating
not only a decade of relative poverty but the rise of the Nazi regime and the fifty million dead
from World War II in Europe.
If there were no reasonable prospect of successfully managing international financial crises, then
the risks of an 1873 or a 1982 or--worst of all--a 1933 would then significantly outweigh the
benefits of capital mobility. But there is every reasonable prospect of successfully managing
international financial crises. The much-larger-than-anyone-anticipated Mexican crisis of 19941995--successfully handled--saw Mexican economic growth resume after a single year of
recession. The East Asian crisis of 1997 generated a sharp but very short recession.
But successful handling of international financial crises requires political and economic skill. It
requires rejecting the arguments of the Wall Street Journal's editorial page that East Asia
"needed" a deep, prolonged recession with mass unemployment to punish entrepreneurs and
banks in NICs who overborrowed. It requires rejecting the arguments of Ralph Nader that East
Asia "needed" a deep, prolonged recession with mass unemployment to punish New York
financiers who overlent. And it requires rejecting the argument that international capital
mobility--good enough to finance the industrialization of the NICs of Australia, Canada, and the
U.S. a century ago--is too risky for the NICs of today.
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The prose of Andrew Mellon, Treasury Secretary for Herbert Hoover, who thought that the
solution to a financial crisis was to:
[l]iquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.... [E]ven a panic is
not altogether a bad thing.... It will purge the rottenness out of the system.... People will work
harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the
wrecks from less competent people.
If institutional continuity leads you to favor lenders-of-last-resort, study the prose of your former
editor Walter Bagehot:
...in time of panic [the lender-of-last-resort] must advance freely and vigorously to the public out
of the reserve.... The end is to stay the panic; and the advances should, if possible, stay the panic.
And for this purpose there are two rules: First, that these loans should only be made at a very
high rate of interest... [to] operate as a heavy fine.... Secondly, that at this rate these advances
should be made... as largely as the public ask for them... [and] on what in ordinary times is
reckoned good security.
Jagdish Bhagwati in Foreign Affairs:
"The overwhelming majority of trade economists judge the gains from free trade to be
significant, coming down somewhere between Paul Krugman's view that they are too small to be
taken seriously [a misrepresentation of Krugman's position, by the way] and Jeffrey Sachs's view
that they are huge and cannot be ignored. But all we have from the proponents of capital mobility
is banner-waving, such as that of Bradford DeLong, the Berkeley economist and former deputy
assistant secretary of economic policy in the Clinton administration:
"So now we have all the benefits of free flows of international capital. These benefits are
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mammoth: the ability to borrow from abroad kept the Reagan deficits from crushing U.S.
growth like an egg, and the ability to borrow abroad has enabled successful emerging
market economies to double or triple the speed at which their productivity levels and
living standards converge to those of the industrial core.
"And of Roger C. Altman, the investment banker, who served in the Treasury Department under
Presidents Clinton and Carter:
"The worldwide elimination of barriers to trade and capital... have created the global
financial marketplace, which informed individuals hailed for bringing private capital to
the developing world, encouraging economic growth and democracy.
"These assertions assume that free capital mobility is enormously beneficial while
simultaneously failing to evaluate its crisis-prone downside…
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