David Lipton, recently reappointed first deputy managing director at the IMF (effectively number two to Christine Lagarde) was at the Peterson Institute recently to give some insights into being 'fireman in chief' for US international economic policy for the past three decades, ready to act 'every time the IMF needed to be second-guessed'.
His career alternated between the US Treasury and the IMF. He was indeed a key figure during the Asian crisis of 1997-98, sitting in an adjacent room while the IMF negotiated its program with South Korea and acting as chief enforcer for the misguided monetary policies in Indonesia in early 1998.
Thus his reflections on the success of these policies, nearly 20 years later, are of interest: [fold]
When Thailand, Korea and Indonesia fell into crisis less than three years later, we learned that even countries with successful policies and access to foreign finance can develop vulnerabilities.
We also learned that global financial markets could focus on those vulnerabilities, move as a herd, and generate a reversal of capital flows – not only for one country, but for many other countries seen as similar. We were forced to re-examine our efforts to promote capital market openness and integration. Many countries came to fear the political and economic costs of financial sudden stops, recession, and banking sector stress. Emerging market countries also worried about market access and began to act more defensively – building up international reserves through intervention.
How this assessment has changed since 1997! When Thailand and Indonesia came under speculative attack in 1997, the key economic problems were seen in terms of domestic policy mistakes: fixed exchange rates, large current account deficits and weak financial sectors. But above all, the diagnosis for Indonesia was 'KKN' (corruption, collusion and nepotism), factors which hadn't stopped Indonesia from growing at 7% annually for three decades.
The remedy was to float exchange rates, ignoring the inevitability that free floating in these circumstances would lead to huge overshooting (as occurred, spectacularly, in Indonesia). Budgets were tightened sharply, which ensured that the downturn became a crippling collapse in economic activity. Troubled banks were closed without provision to prevent contagion, which brought down the entire banking system. Interest rates were raised drastically in the misguided belief that capital outflow would reverse and the exchange rate rout would be halted. All it did was bankrupt borrowers. A shopping list of structural conditionality was imposed (desirable for the long run, but in the middle of a crisis this was like insisting that a bleeding road accident victim take a pledge to give up smoking).
With the Indonesian rescue program in chaos, it was easy to add an uncooperative President Suharto to the list of problems that had to be dealt with. The final straw was the program requirement to raise petroleum prices sharply, always a super-sensitive political issue. The resultant riots in May 1998 brought about Suharto's resignation (one senior American had told me earlier in January that 'the quicker this fucking regime goes, the better').
Now the story can be re-written in a way that makes more sense. In the years leading up to the crisis, capital markets were opened up to foreign inflows too quickly and for no good reason (Stan Fischer, who led the IMF's Asian rescue operations in 1997-98, now asks 'what useful purpose is served by short-term international capital flows?'). The excessive inflows pushed up exchange rates (leaving them vulnerable to speculative attack). The inflows overextended bank balance sheets and created a speculative boom in assets. Domestic borrowers took out loans in foreign currency, which bankrupted them when the exchange rate collapsed. The crisis response was seriously flawed. Unlike in Mexico in 1994, there was not enough external funding assistance to stabilise the capital outflow. Direct intervention to limit capital outflows and 'bail-in' foreign creditors was specifically ruled out by the IMF, even though it was later successfully applied in South Korea and had been a central element of Poland's 1989 reforms.
How could the rescue operation have been so misguided? Perhaps one clue is David Lipton's own description of his prior experience:
Working with Jeff Sachs, we did what graduate students do: we built a mathematical model, fancy for its time (with two countries, fully maximizing, infinite horizon, rational expectations, etc.).
After this, he worked with the IMF on the Latin American crises of the 1980s, and with Jeff Sachs on Poland (usually regarded as a successful, if painful, transition from a command economy to one based on markets). He observed Mexico during its 1994 crisis, where excessive capital inflows were the core problem. Thus there is no excuse for missing their key role in Asia three years later. But none of this fitted the textbook model of capital flows, where:
Everyone gains: the poor country experiences a boom and living standards converge upward. Even the rich country gets richer as investors reap returns to capital higher than any available at home.
The operational lesson he learned from the IMF, Jeff Sachs, and Poland was to see economic reform as a matter of revolutionary change ('shock therapy'); to swiftly impose market-based systems and slash the role of state ownership. The failure, as usual, was with Douglass North's 'institutions'; the absence of deeply embedded norms of behaviour which are necessary for markets to work well. Like many IMF staff, he was well-equipped in book learning, but the practical application was distorted by preconceptions about how well markets (particularly financial markets) would work in these environments. The neoliberal agenda guided policy.
Belatedly, lessons were learned, but only through experiencing crisis at home a decade after the Asian Crisis. The lessons of 1997-98 were seen as applicable only to developing economies. The response to the 2008 crisis could hardly have been more different: interest rates were lowered dramatically; fiscal policy was eased (at least initially); and financial institutions were shored up with massive government funding.
Larry Summers gives David Lipton credit for shifting the IMF to a more accommodating attitude to fiscal consolidation during the recovery from the 2008 crisis. The IMF has also shifted rhetoric on capital flow management, even if it's hard to see evidence of an operational shift. There is a long way to go. Most relevant to crises such as Greece, adequate sovereign debt restructure seems as distant as ever.
The enduring legacy of the 1997-98 Asian crisis is that Asian policy-makers are adamant they will never again ask for IMF assistance, preferring inefficient self-insurance in the form of current account surpluses and large foreign exchange reserves to the risk of finding themselves once again subject to IMF policy strictures.
Photo: Getty Images/Milos Bicanski